This Cheap Stock Is Still a Buy Even After 50% Rally

Tencent Holdings TCEHY is enjoying a revival in its stock price in 2024: The shares are up 50% year to date. But even after the rally, this wide-moat stock remains well off its 2021 highs. The internet giant’s products and services are embedded in the daily lives of Chinese citizens; WeChat alone has 1.3 billion users. Whether the Chinese government’s massive stimulus package will be enough to overcome the market pessimism around Chinese stocks long-term is debatable, but there’s no debate about Tencent’s attractive valuation. Tencent is among Morningstar chief US market strategist Dave Sekera’s 5 Stocks to Buy Instead of Overpriced US Equities. It also lands on our list of 40 of the Best Investment Picks.

Tencent has capitalized on the industry shift toward mobile gaming. It owns some of the world’s most popular titles, like Honor of Kings and PUBG Mobile. We expect Tencent to 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 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 increases monetization through advertising and acts as a major gateway for other internet services (payment, delivery, insurance, and so on) looking to access its 1.3 billion users. While games and advertising will remain core cash flow drivers, we believe the firm’s leading position in payment, cloud storage, and enterprise software offers significant long-term value-creation potential.

Key Morningstar Metrics for Tencent

• Fair Value Estimate: $90
• Star Rating: 4 Stars
• Economic Moat Rating: Wide
• Uncertainty Rating: High

Economic Moat Rating

Tencent’s wide moat is primarily based on network effects around its massive user base. We believe the company also possesses secondary moat sources like intangible assets, cost advantage, and switching costs. Unlike other messaging apps, WeChat is a platform for daily life and work: Through in-app features, users can play games, read news, perform searches, watch videos, listen to music, and shop. As of June, WeChat users numbered 1.3 billion, effectively covering almost the entire Chinese population. We think the value of Tencent’s network increases for new and existing users as more customers use WeChat. Tencent’s adjusted return on invested capital has been well above its 8.3% weighted average cost of capital for the past 10 years, and we believe that the company will continue to leverage its user base to generate returns above WACC for the next 20 years.

Read more about Tencent’s moat rating.

Fair Value Estimate for Tencent Stock

About three fourths of our valuation comes from Tencent’s core business, with the rest from its investments. We forecast a five-year revenue compound annual growth rate of 15%. We expect operating margins will level off as the positive effects of operating leverage are offset by an unfavorable mix shift toward less profitable segments. We forecast a five-year adjusted earnings CAGR of 17%. We assume adjusted EBIT margin (excluding other gains) will plateau at around 20% over the next two years before expanding to 32% by 2031 as current investments start generating more returns. The main long-term gross margin driver lies in financial technology, cloud, and various business-to-business services.

Read more about Tencent’s fair value estimate.

Risk and Uncertainty

Tencent faces significant risks from tightening regulations involving finance and gaming. In addition, the internet industry is highly competitive and volatile. Tencent’s investments in loss-making future growth businesses may weigh on overall margins. Weak macroeconomic conditions, pandemics, and shifting consumer sentiment can negatively affect Tencent’s profits, especially in advertising. And WeChat’s dominant status raises concerns about potential data overcollection and abuse, risking government fines.

Read more about Tencent’s risk and uncertainty.

Tencent Bulls Say

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

Tencent Bears Say

• Chinese regulators have become more assertive. There is always the possibility 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.
• It’s possible that highly competitive foreign internet service providers will reenter China over the next 10-20 years.

This article was compiled by Susan Dziubinski and Sylvia Hauser.