Tencent: High Margin of Safety (OTCMKTS:TCEHY)

Tencent Holdings Limited (OTCPK:TCEHY) stock is trading at an unfairly low P/E ratio despite the Chinese tech company reporting Q1 results. I think Tencent represents good value because the telecom company is growing, especially in online advertising. The company’s focus on cost control is paying off in the form of soaring gross margins, and Tencent continues to generate massive free cash flow. I think investing in Tencent reflects a high margin of safety, and US investors are too hesitant to buy promising Chinese large-cap stocks!

Previous evaluation

I rated Tencent a strong buy in April 2024 due to its fast-growing online advertising business and strong core business profitability. I also noted Tencent’s low valuation at the time, but the tech company’s stock is still The company’s favorable business trends. Tencent also had strong free cash flow last quarter and had a free cash flow margin of over 30%, so I think Tencent is attractive as a capital return play going forward.

Q1 24 solid growth, sharp increase in gross profit

In Q1, Tencent reported a 6% increase in revenue, bringing its quarterly revenue to 159.5 billion yuan ($22.5 billion). Tencent is one of the top three Chinese large-cap stocks and owns several online and social media businesses. Tencent is currently doing particularly well in online advertising, with its Q1 2024 earnings card showing 26% year-over-year growth in this important business. Tencent’s revenue growth has moderated over the past two years as China’s economic growth has slowed, partly due to COVID-19, but its gross profit trajectory looks promising.

Tencent’s gross profit is soaring (+23% Y/Y) to 83.9 billion yuan ($11.8 billion) in the March quarter. Driving this growth is a focus on costs and a review of strategic priorities. For example, Tencent decided to shut down its online education platform with about 400 million users to focus more on profitability.

The decision to shut down its online education business stems from a desire to focus on the company’s core businesses, such as communications. Tencent, often called the Facebook of China, owns Weixin (also known as WeChat), China’s largest communications app with 1.4 billion monthly active users.

Tencent’s “value-added services,” which include its social networking business, account for more than half (54%) of the company’s total profits… Online advertising accounts for 17%. The online advertising business, which I mentioned in April as supporting my bullish view on Tencent, is the Chinese company’s fastest-growing core business.

Capital gains potential

In addition to increasing gross margins, Tencent could potentially be an attractive investment for investors looking to generate capital gains by refocusing on core business activities such as social media and online advertising.

That’s because Tencent generates significant free cash flow, and its recovering online advertising business, along with strategic cost cuts, has been driving significant free cash flow tailwinds in the past quarter. In the most recent quarter, Tencent generated 51.9 billion yuan ($7.3 billion), up 52% ​​quarter-on-quarter.

Free cash flow margins have also expanded, reaching an impressive 33% in Q1 2024 compared to 22% in Q4 2023. Much of this free cash flow can be returned to shareholders in the future, making Tencent much more attractive to investors from a stock buyback perspective. In the current fiscal year, Tencent announced plans to buy back HK$100 billion (US$12.8 billion) worth of its own shares. In Q1, Tencent bought 51 million Hong Kong shares for a total of HK$14.8 billion (US$1.9 billion).

Tencent’s valuation

Like Alibaba (BABA) and Baidu (BIDU), Tencent is also trading at an absurdly low P/E ratio. Tencent is valued at 13.9X P/E based on FY2025 earnings estimates, while Alibaba is at 8.1X and Baidu is at 7.6X. I think all three Chinese large caps are cheap on an earnings basis, with Alibaba and Baidu showing much deeper earnings valuations than Tencent. Alibaba in particular can be considered a return on equity, as the e-commerce company recently announced a special dividend and is set to buy more shares in the future.

Tencent is a strong earner because its EPS is growing at a rapid pace. However, while Alibaba and Baidu are expected to see negative EPS this year, Tencent is expected to see EPS growth of 34% due to comprehensive cost restructuring and continued momentum in online advertising.

Given Tencent’s strength in free cash flow and gross margin, strong EPS growth, and momentum in online advertising, we are raising our fair value P/E ratio from 15x to 15-16x. This implies a fair value range of $52-56. This is a dynamic number and could decrease or increase depending on Tencent’s progress in terms of core business momentum, free cash flow margin, and acquisition of discounted shares in the market.

Tencent’s Risk

The biggest risk for Tencent is that growth in its online advertising business could slow down… that’s where all the action is going for the company right now. As I’ve said in the past, a potential Taiwan invasion could be a risk factor for Chinese stocks overall. What would change my mind about this tech company is if top-line revenue growth in its social media business slows or free cash flow (margins) deteriorates.

Final Thoughts

Tencent has a lot to offer and may even be more than investors are giving it credit for. Tencent, like Alibaba and Baidu, has not been very popular with US investors, but the company is growing its gross profit rapidly, has strong underlying free cash flow, and its stock is cheap. Alibaba has also recently increased its share buybacks and paid a special dividend, a strategic decision to make the stock more attractive to investors outside of China. Tencent’s core business is doing well, especially online advertising, which has improved profitability as it focuses more seriously on cost control. The stock is still cheap and, in my opinion, reflects a high margin of safety at its valuation!

Editor’s Note: This article discusses one or more securities that are not traded on a major U.S. exchange. Please be aware of the risks associated with these securities.