Tencent's Stock Is Severely Undervalued

Bulls Say

• Many of Tencent’s products are still in the early stages of monetization.
• Because Tencent is so deeply integrated in the Chinese daily life, it can easily test new monetization methods and pick the best ones to implement.
• Compliance costs could rise to a point where they become significant barriers to entry to the Chinese Internet industry.

Bears Say

• Chinese regulators have become more assertive in recent years. It’s possible that the government may want more control over Internet businesses by curbing monetization, limiting collection of user data, or restricting acquisitions.
• Tencent found success by riding the wave of mobile Internet, but this is no guarantee that it can stay at the forefront of next-generation technologies.
• Highly competitive foreign Internet service providers could possibly re-enter China in the next 10-20 years.

Morningstar Analyst Ivan Su Says

Over the past decade, Tencent (TCEHY) has capitalized on the industry shift toward mobile gaming. The company owns some of the world’s most popular game titles, like Honor of Kings and PUBG Mobile. To date, games remain Tencent’s primary monetization model, as we estimate more than 40% of the company’s operating income comes from this segment. Tencent should continue to leverage its unrivaled access to user data and financial capital to create innovative, high-quality, and long-cycle games with a mobile-first approach.

Other key businesses in the Tencent empire include WeChat, QQ, WePay, music streaming, on-demand cloud, and a host of other ventures. We see a tremendous amount of untapped value in WeChat, as it continues to increase monetization through advertising and acts as a major gateway for other Internet services (payment, delivery, insurance, and so on) looking to access the 1.2 billion-plus WeChat users.

Given WeChat’s huge and engaged user base, advertisers will continue to find it one of the top marketing channels. We think there are ample advertising revenue opportunities ahead, driven by rising advertising inventory, higher ad loads, and improving ad-targeting efficiency.

While games and advertising will remain Tencent’s core cash flow drivers, we think the company’s investments in areas like cloud storage, business services, and enterprise software also offer long-term value-creation potential. Given the size of China’s economy and the prevalence of digital adoption, we surmise that there are enormous opportunities ahead for enterprise technology, and Tencent will most likely become a formidable player in the industrial Internet space.

Tencent is also an investment powerhouse, and it loves using deals to expand its reach. Once invested, Tencent tends to add value through highlighting investees’ services on WeChat and other in-house traffic platforms, reducing customer acquisition costs while helping them scale rapidly. This strategy has paid off nicely, as external investments have generated an estimated internal rate of return above 20% over the past decade.

Key Proprietary Morningstar Metrics

Fair Value Estimate: $108
Star Rating: 5 Stars
Economic Moat Rating: Wide
Moat Trend Rating: Stable

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