Tencent (OTCPK:TCEHY) is a fantastic business with some strong long-term prospects. It has been unfairly caught up in the back and forth of the US-China trade war. However, the near-term trade dispute will not damage the long-term potential of the business. It is a core holding in my Project $1M portfolio.

WeChat is an undermonetized asset with significant network effects

While Tencent is best known for its strong gaming business, which includes such titles as Honor of Kings, it is really WeChat that will be the key to this company’s long-term success. This is probably just as well, given that the Chinese government has been actively increasing the regulatory pressure on gaming titles in the market generally over the last 12 months. While the noose has slowly started to loosen, it’s highly likely that the revenue and profitability in this sector for the likes of Tencent will not be the same going forward as it was historically.

WeChat functions as the daily social communication tool and digital concierge for almost 1B people, mostly in mainland China. In particular, WeChat has become the digital epicenter of life for millennials in mainland China. It’s not just social communications that WeChat helps manage, but everything from money management to payment to taxi booking to food ordering can be done from the comfort of the WeChat app.

The WeChat service stack, Source: A16Z.com

The network effects of this business are truly stunning. Of course, being connected with all of the people in one’s social circle helps ensure a significant element of usage and engagement and makes it difficult to leave. However, the fact that WeChat has layered on so many daily utility services and functions within the application has elevated the status of WeChat to a life management tool, which would be almost impossible to replicate without a significant degree of difficulty for the user. This provides WeChat with an element of stickiness that makes it highly unlikely to be ever displaced. The significant user utility leads to incremental users joining the platform, which in turn attracts additional developers to create additional content for the platform, adding to user utility and engagement. With over 1B daily active users, the ability for a competitor to displace a property with so much utility becomes prohibitively expensive, if not impossible. WeChat users tend to log into the application 10x per day. WeChat accounts for a staggering 34% of all mobile data traffic in China, with 17M official accounts and is the 5th most used application in the world. One-third of users spend over 4 hours a day on the platform.

The truly impressive thing about WeChat is that monetization of this property has barely scratched the surface. Tencent has been slow to monetize WeChat with advertising, preferring to get the user experience right. Only earlier this year, it made the decision to increase the ad load on the WeChat user newsfeed from 2 ads to 3. Compared with Facebook, the overall ad load on WeChat is very small, considering the various ad inventory units available to Facebook across newsfeed, video pre-rolls and other sponsored ad content on the Facebook property. It can also be expected that various brands will be willing to pay handsomely for the chance to promote content to more than 1B users. Given the turmoil in the company’s gaming business, this is something that Tencent recognizes and wants to release the latent potential here. Tencent has apparently targeted increasing advertising revenue as a contributor to its overall business objectives from 20% of its business today to around 40% in 2-3 years time.

Tencent functions as an innovation factory

In addition to having several scalable, rapidly growing businesses in its own right, Tencent also has investments in a broad breadth of emerging early stage venture backed businesses. Tencent has more than 700 investments in companies globally, with more than 40% of these investments outside China. This aggressive approach to tapping into market based innovation helps Tencent stay abreast of new areas and lines of business that the company can leverage and double down on. In addition, the growth and traction of these businesses when they hit new milestones results in progressive increases in valuation for these businesses, which Tencent is also able to recognize as a profit contributor.

Tencent has a long runway of growth ahead of it

Tencent recently announced earnings which were very robust. Overall revenue growth increased 21% for Q2, with operating profit up 26%. Online gaming produced a noticeable, albeit modest, rebound in revenue growth, up 8%; fintech and business services was up some 37%, with digital advertising up 16%. What was evident from Q2 results is that the areas of more significant growth such as digital advertising and cloud services are both areas where Tencent is making more significant investment for its business. Tencent recently announced a strategic restructuring which is indicative of an increasing positioning on enterprise facing markets. While a greater push into advertising is certainly a part of that, Tencent also has its sights set on capturing more of the Industrial Internet over the medium term. This will include a focus on AI and 5G technologies, much of which will be powered by Tencent cloud.

The core markets that Tencent plays in today, such as advertising and gaming, have long runways ahead of them. The digital advertising market in China is expected to grow in excess of 70% over the next 5 years, with Tencent being a significant beneficiary, along with Baidu (NASDAQ:BIDU) and Alibaba (NYSE:BABA).

Digital Ad Spending in China, Source: emarketer.com

As Chinese consumer discretionary income increases, and as they spend more and more time online, much of it on Tencent’s WeChat platform, advertisers will want to ensure that they have a way to connect with these customers.

The gaming market in China has certainly lost some luster post a more aggressive regulatory posture from the Chinese government; however, mobile gaming is still expected to average low double-digit growth for the next 3 years.

Cloud computing as an area is expected to see particularly aggressive growth. According to IDC, China’s cloud market is expected to grow at a rate of almost 44% p.a. CAGR over the next five years. Tencent can be expected to play a significant role here, along with the likes of Alibaba.

Recent Pullback makes Tencent appear attractive

Tencent has come back quite some way since touching a high of $51 per share earlier in the year given concerns around the US-China trade war. At a current price of $43, Tencent trades at a forward PE of 30x earnings, close to the average of where its been over the last 5 years, and putting it on an expected PEG ratio of 1.6x earnings, which is attractive for a business that has grown operating income at close to 30% annually over the last 3 years.

Given Tencent’s attractive positioning in key growth markets and the strong beachhead that WeChat occupies in the lives of 1B daily active users in China, any entry into Tencent at these levels is likely to reward investors well.

Disclosure: I am/we are long TCEHY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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