Why We Stay Away From Tencent

We remain concerned with the growth strategy and competitive landscape despite our respect for the longtime success of the business and its founder Continue reading... Read More...

With a mission to “build connections,” Tencent Holdings Ltd. (HKSE:00700) is the world’s largest gaming company, China’s largest social media platform (mainly consisting of QQ and WeChat), one of the world’s largest internet companies and one of its largest investment companies. The company is truly a technology conglomerate, owning hundreds of products that span across various categories, including social networks (23% of third-quarter 2019 revenue), online games (29%), online advertising (19%), fintech and business services (28%) and others (1%).

Admittedly, Tencent is one of the most successful Chinese companies listed outside of the mainland, with a solid track record of delivering tremendous value to both shareholders and its users. The company was founded in 1998 by legendary Chinese entrepreneur Huateng Ma, who still holds the role of chairman and CEO with an over 8% equity stake. While we do have lots of respect for the longtime success of the business and its founder, we remain concerned with multiple facets moving forward.

First and foremost, the acquisition and investment-driven growth strategy worries us. Some of the company’s most prominent deals in recent years include Pinduoduo (NASDAQ:PDD), Snap (NYSE:SNAP), Meituan Dianping (HKSE:03690) and JD.com (NASDAQ:JD). These businesses vary in terms of verticals, from e-commerce to life services, social media and even ride-hailing services. But they do have one thing in common – they are all loss-making businesses. Per the chart below, none of the companies mentioned above are generating any profit at the moment. One could argue that this is commonly how the internet-based business model works in its early stages, but why bother sticking with these ventures, especially when alternatives with cash-rich operations and better predictability are available in other spaces?

In the meantime, we see a lack of substantial moat to protect the majority of Tencent’s businesses. Probably the most sustainable competitive edge comes from the one-sided network effect through social networks (i.e., WeChat and QQ) the company owns. In light of the incredibly intense competition in China’s technology sector, however, any type of moat appears conquerable. We have observed how ByteDance keeps disrupting one vertical after another and stealing market share rapidly from once unshakable Baidu (NASDAQ:BIDU). Peter Thiel one said, “Competition is for losers.” In our opinion, Chinese technology conglomerates love to diversify and compete, which seems to make almost everyone a “loser” in the end.

Looking at Tencent’s other business segments, we see that online gaming is the most significant contributor to the top line. As with our previous assessment on Evolution Gaming (OSTO:EVO), we feel a bit speculative for this space. That is, there is little long-term predictability that future games can harvest the same success as their predecessors.

Also, The fintech and business services segment is a rising star within Tencent, growing at more than 30% per the latest filing. Nonetheless, we will continue to carefully watch the developments in this space as the business-to-business model mostly falls outside of the company’s core competency with a business-to-consumer product gene, let alone the never-ending competition from Alibaba (NYSE:BABA).

In terms of financials, serial acquisitions and a narrowing moat that has to be continuously rebuilt can mean a deteriorating cash return on capital with surging goodwill on the balance sheet, which is illustrated in the chart below.

Disclosure: The mention of any security in this article does not constitute an investment recommendation. Investors should always conduct careful analysis themselves or consult with their investment advisors before acting in the financial market. We own shares of Evolution Gaming.