One of the World’s Widest Moats

Posted on Posted in Investment Ideas & Company Research, Saber Capital Management

A year ago today, I wrote a short post on a company called Tencent Holdings (TCEHY), a dominant internet company in China and its ubiquitous crown jewel of an app platform called WeChat. I began studying that company for a few months, and last fall I bought some shares for the first time, adding some more shares in December. The stock has risen this year, but still offers significant value in my opinion, and I plan to hold my shares for the long-term as I believe the company is likely to compound at attractive rates over time.

Last month, I did a presentation for the Manual of Ideas on Tencent that I wanted to share here with readers.

There are four things I like about Tencent: the huge network effect of WeChat, the massive runway for growth, the high returns on capital and significant free cash flow (despite barely scratching the surface of WeChat’s potential), and the fact that the company is run by its driven, long-term focused founder who remains one of the major shareholders.

The slides outline these four advantages, as well as go over in more detail how I think about the valuation of Tencent, which I view as a long-term compounder. I’ll have a bit more to say on Tencent in Saber Capital’s next investor letter, which I’m writing this week, but these slides should cover in detail why I like the company and the investment.

Again, the stock is up quite a bit in recent months, and I have no idea where the stock goes in the next year or so (as is the case with any stock), but I think over a long period of time Tencent shares will likely compound at a rate that roughly mirrors the growth of the company’s intrinsic value – and I think this rate of compounding will be quite high for a number of years to come.

Download (PDF, 2.77MB)

 

Disclosure: John Huber and clients of Saber Capital Management own shares of TCEHY. Please do your own due diligence. This is not a recommendation to buy shares. 


John Huber is the portfolio manager of Saber Capital Management, LLC, an investment firm that manages separate accounts for clients. Saber employs a value investing strategy with a primary goal of patiently compounding capital for the long-term.

To read more of John’s writings or to get on Saber Capital’s email distribution list, please visit the Letters and Commentary page on Saber’s website. John can be reached at john@sabercapitalmgt.com. 

20 thoughts on “One of the World’s Widest Moats

  1. Hi John – new reader here. Love the content and clear logic you present in your posts. Just had a question on your conclusion in p.53 saying you believe 15-20% growth from the current share price of $35 is possible. How did you determine $35 was a reasonable value to begin with? Specifically, although the company’s margins and growth prospects are attractive, why don’t you believe all of that (and more) is already reflected in the current $35 share price? Doesn’t seem like Tencent is an under-followed or out of favor company (particularly nowadays with all the interest in tech)?

    Thanks!

    1. Hi Bilt,
      Thanks for the comment. And good question. I tried to lay out why I think there is a lot of value in the slides toward the back of that presentation. Keep in mind the stock is up from the time I presented it, so some of those valuation numbers would have to be adjusted. But a couple comments: first, I think a lot of investors believe something has to be hidden or unloved to offer significant value. The idea that everyone knows about Tencent doesn’t necessarily mean it is priced accurately. The power of WeChat was clear a year ago, and even two years ago, but the stock has doubled since in the last year or 18 months, so the argument could have been made that it was well-known then, but it was still undervalued. Of course, someone could argue that the stock is overvalued now, but my point is that large cap, well-followed stocks can be significantly misplaced from time to time (Tencent, and other large cap stocks, as I point out in the presentation, have widely varying prices in any given 52 week period). So, I think it’s helpful to keep in mind the idea that just because it’s large and widely followed doesn’t mean value isn’t present.

      As for the current valuation, take a look at my slides on the return on capital the company is producing, along with my estimate of the rate at which the intrinsic value of the business is growing at. Coincidentally, the company announced their latest earnings this morning, and revenue is growing at 59%, profits are growing at 45%, the company has 40% margins and produces huge returns on capital. Also, the size of the markets they operate in (mobile advertising, online shopping, mobile payments, cloud) are massive, and growing fast. There is a long runway ahead. In short, I think 40 P/E’s on very rare occasions can significantly undervalue the future stream of earnings.

      Hope that helps. Thanks for reading!

  2. Hi John

    You may be aware, but there is a company listed here in South Africa called Naspers (NPN on JSE if look on google finance), which owns something like 35% of tencent and trades at a significant discount to the value of it’s holding in tencent, and has some other very cash generative businesses that you effectively get for free.

    Regards,
    Ross

  3. Hi John,

    I enjoyed reading your presentation on Tencent. I was wondering, what do you think about getting exposure to Tencent through ownership of Naspers? There seems to be some discount available there, which is either warranted or not?

    I would love to hear your thoughts on it!

    DGI

  4. Thanks for the post. Very new to the story but it seems to me that Tencent is largely still a game company (gaming is probably 57% of revenue and 66% of profits with game sales from Social included). If the play is largely on ad, I am sure ad will continue to grow but not sure how big it would become. If China digital ad is already $50bn, it means it is close to 2x the size of TV ad and +50% of all ad spending (not much tailwind from analog to digital switch). So not much green land to grab unless digital is 70% of total spending. If most of ad growth is share gain, how much would Baidu lose to feed Tencent’s growth? Besides, WeChat feels very different from Facebook. It is more like Whatsapp (communication first and foremost) and it is cumbersome to check all the feeds/moments (2 clicks at least). Lastly, its ROIC is fantastic but I think it mostly comes from game side (any successful gaming company would have very high ROIC until new releases flop). Video business has two other dominant competitors owned by Alibaba and Baidu. Cloud is the same story so not sure what ROIC excluding game is. I think ad + social ROIC is high but other segment ROIC is negative but is growing very fast.

    1. Thanks for the comment Steve. Yes, some businesses are ultra competitive. For example, mobile payments is a massive business in China but not yet profitable for Tencent, partly due to cutthroat competition with Alipay (although gross margins are improving dramatically as it scales larger). The video subscription business is also hugely competitive with Baba and Baidu bidding competitively for content. I think some of Tencent’s businesses are certainly better than others, but WeChat I think is going to be massively profitable over time. Tencent had 12% of the mobile ad market in China last year. Two things: the digital ad market overall is growing at 25%+ per year in China, and mobile ads are growing much faster than that. Two, Tencent had just 12% of the mobile ad market. So I think it’s very likely that a) mobile/video ads will continue to grow at fast rates over the next decade b) Tencent will have a much bigger piece of that growing pie. It’s also not a zero sum game (meaning, the overall advertising pie will grow as the overall consumer economy continues to grow). So while Tencent will take a greater percentage of growth going forward, Baidu and certainly Baba will do well also (their percentage of the pie might shrink, but the pie is growing fast and they’ll take a good chunk of the growth as well).

      Overall, the game business is a cash cow and growing, and you’re right that a majority of profits come from publishing games (not a bad thing – the gaming business in China is a big business, and is also growing). I like the risk/reward with the investment because the cash flow from the games will continue to grow (at slowing rates, but will still grow fast by most standards), and I think there are a few businesses inside Tencent that could be home runs (specifically, mobile advertising and ecommerce – two businesses they’ve barely scratched the surface on, other than through their stake in JD).

      Just some thoughts… thanks for reading Steve.

      1. Hey John,

        Your blog is my absolute favorite. I love the Tencent idea, other than risk from the Chinese government potentially saying Tencent is getting too large (I’m speculating) – I don’t see what can stop this growth machine.

        I’m sure you are aware that Naspers has a 34% stake in Tencent and my back of the envelope math says with Naspers at a 90B MC and several other potentially valuable stakes/business this discount to NAV is wide and has gotten wider as Naspers has lagged the Tencent runup. I read where the Naspers CEO doesn’t want to spin it, but being a long term investor you get a free call option on them somehow maximizing value via a spin or selling some back to Tencent at some point over the next several years.

        The Yahoo, now Altaba, story strikes me as eerily similar, Yahoo had a ~15% stake in BABA that was worth way more than its MC and the activist from Starboard Value stepped in and basically got them to sell the core business to VZ for 4B, they had 5B net cash and the baba/Yahoo Japan stakes. YHOO/Altaba has far outpaced BABA’s huge run because of the sales and baba spin by the company.

        Would love to hear your input on Naspers being a way to play Tencent.

  5. Hi John,

    Thanks for the reply and I really appreciate it. I am new to the story and haven’t read any transcripts or much reports yet. Just some thoughts or questions

    1. Ad market: US digital ad is about $70bn in 2016 and China at $50bn (as you cited). If China digital ad is growing at 25%, it will be 80% of ad market in 2018 (I think ad market size is about $185bn in US and $100bn in China in 2016, global ad market size at $550-600bn range) unless the market size is somehow enlarged by engulfing promotion (likely). Why do you think all three (Baidu, Tencent and BABA) will do well in this scenario? It seems the industry structure is gearing towards consolidation (GOOG and FB account for 80-90% of ad growth, it is a duopoly in eCommerce in China between JD and BABA). I am inclined to think Baidu will suffer but not sure how big Tencent will become. Webo seems to be doing really well in this area. In mobile ad, I would definitely include Webo.

    2. I am more positive on mobile payment given that it is $3.2tr industry in 2016 (if this number is true);

    3. I am not sure how mobile eCommerce is panning out (unless you put that into mobile payment category). This is mostly O2O (at least to me). Not sure if there is any disclosure on how big and how the progress is made in any conference call yet. My intuition is this should be put into mobile payment category.

    4. Could we see gaming rev and profitability down in the future? If it is starting to grow slower and some games don’t work out, it would put a major drag on growth or profit. Historically, there seem just no company is able to stay at top of game category.

    As such, we have an interesting combination of all these dynamics. Just some of my random thoughts and thank you always for sharing your research.

  6. Dear John

    I always read with great enthusiasm your blogs and investment considerations. Thank you very much for making them public!
    Basically, the same question as the Dividend Growth Investor above. The FPA Crescent fund released their Second Quarter 2017 Commentary, where they describe their Naspers / Tencent Arbitrage (please see below the link to the description).
    http://fpafunds.com/docs/quarterly-commentaries-crescent-fund/fpa-crescent-fund-commentary-2017-q2.pdf?sfvrsn=2
    Naspers owns 33% of Tencent and is valued substantially less than its Tencent stake alone. I wondered as well, if you thought about owning Tencent over Naspers and what your thoughts are on it?

    Thank you

    Sat

    1. It’s a great point. I have begun thinking more about Naspers. Initially, I wanted to invest directly in Tencent because I didn’t really care (or I should say, I didn’t really know) all that much about the other businesses inside Naspers. I also wasn’t familiar with Naspers management, and there were some risks I didn’t care for in the South African economy and political landscape (those haven’t gone away, and while they are unlikely to affect Naspers’ investments, I wasn’t 100% comfortable on what (if any) impact those risks (should they come to fruition) have on Naspers itself). I think those risks are probably minimal though. So one reason for choosing Tencent directly was I thought it was less complex. The other big reason is that the discount is now much larger than it was previously. So the discount, plus my interest in a few of their Indian investments, has me interested in Naspers. I am looking at it now.

  7. Hi John

    Interesting presentation. This company has everything to do with growth, but not very much to do with value. Compounding at high returns is a wonderful idea. If only we knew future returns. Five years ago, the ‘razor blade model’ would have been the epitome of a moat. Now, as your presentation says, we’re not so sure. Maybe we should stick with statistically cheap companies. History says that works.

  8. My wife (who is Chinese) uses Tencent QQ a lot, especially with all her Chinese friends. It is obviously a super strong business model. One interesting point you made is so many services are in the QQ system, so it becomes far more convenient to just stay within that ecosystem rather than to bother venturing outside it (installing other apps, entering personal and payment information, etc). So my experience is consistent with your observation there. The service to me seems way more sticky than comparable U.S. businesses like Facebook because one can just carry out payments, taxis, online shopping, etc all from one app.

    Another interesting point is that the labor cost in China is generally lower so there are actually many more inexpensive and great services such as same day delivery of a massive variety of produce and prepared foods, flowers, etc to the home that are quite convenient. In comparison, Amazon has some “same day” delivery option in the U.S. where in select cities, one can order by Noon and receive goods by 9 PM. But I recall my wife browsing through different fruit vendors (she is highly picky about fruit quality), selecting all sorts of interesting and exotic fruits that we cannot even buy here in the U.S., and an hour or two later the fruit delivery person was at our door (and they explained more about their fruit selection in person), for a pretty low labor cost. What I am getting at is that the low labor costs make the already highly entrepreneurial Chinese people (more so in my opinion than Americans — I am always disappointed with how slow and static our economy is when I return to the U.S.) be able to add a lot of value in small or “low-end” services that in aggregate I think would really add up for companies such as QQ. As Feynman said, “there is plenty of room at the bottom…”

    1. Oops, I meant to say “WeChat,” not “QQ.” I tend to mix the two up, because my Chinese friends and colleagues used to use Tencent QQ but now they use Tencent WeChat.

      Anyway, nice investment idea, especially Sat’s comment about the Naspers conglomerate discount. I should have noticed this one years ago because of the friends and colleagues using Tencent’s apps.

  9. Hi John,

    Great post. I really liked the moat you described around WeChat. In recent years, Tencent’s operating margins have some investment gains (https://www.bloomberg.com/gadfly/articles/2017-08-16/tencent-profits-from-a-different-game). What are your thoughts on it? Considering they are investing heavily in other companies, it can be considered part of their operations but at some point in the future they might have fewer attractive investments to make.

  10. Your presentation is well laid out, but there is a huge problem with it – I can change the price of Tencent from $35 to $70, and you could still give the same presentation laying out the same “thesis”.

    1. Hmmm… not sure I follow that. If the stock price is twice as high, future returns will be half as good. In any investment, the price paid has to be the ultimate driving factor: are you getting more value than you are paying for? At some price, the answer to that question is no with Tencent, just like with any other investment. I just think at the current levels, there is still a lot of value. I’m not saying it would be over valued at 70, but it obviously would be far less attractive (and maybe it is over valued). The way I valued it was by approximating the cash flow I think the business will generate five years out, and deciding what I think it’s worth… basically a back of the envelope DCF. I think the company is going to continue to compound intrinsic value well past that time horizon though…

      1. The reason I have this impression is there seems to have only one small point that ties the thesis with the price you’re paying, the mention of “15-20% expected return”. It wasn’t at all apparent how that was arrived, and to me if the price doubles nothing in the presentation precludes the 15-20% return expectation. I’m sure you have thought through the valuation to arrive at that number, it just wasn’t apparent (to me at least) in the presentation.

        I agree with you that largely, widely followed, and loved businesses can be cheap too, but there usually is a reason it is cheap and investing is about offering a differentiated view to the market. For me the presentation doesn’t answer a key question: why is it cheap? Why is this opportunity available to me? What is everyone missing? Again this is just a personal preference but to me a thesis becomes much more rounded when it considers the reason something is undervalued. You can’t disagree with something you don’t know.

  11. Hi John this was fantastic reading as always, but I couldn’t help thinking aren’t there cheaper ways to access this same growth market or its periphery? Take SINA corp which trades below the market value of its interest in Weibo (the spread developed as Weibo’s stock rose meteorically).

    Secondly, how come you include equity method investments and AFS securities in “invested capital?” those LT investments are mostly publicly traded companies and actually they contribute negatively to Tencent’s income statement, and they’re massive. Since Tencent’s not in the business of stock purchases, shouldn’t these be excluded? Thus, you’d basically have a business that needs no capital at all to be run (this makes sense given the nature of prepaid gaming credits…a very different business model from the console/video game makers of the past).

    Thanks!!

    1. Yes, I am calculating the returns in a different manner than most might calculate them. The ROIC would be much higher if you exclude some of Tencent’s investments, certainly the equity investments (like Tesla for example) that are unrelated to their core businesses. However, I wanted to get an overall view of where the cash flow is going, and what the consolidated return on those investments have been (including both the great businesses like mobile advertising which takes very little capital, as well as the other investments that have soaked up some of Tencent’s FCF). In other words, you want to look at all of those investments, because we’re trusting that Pony Ma in company will make good capital allocation decisions with the free cash flow that Tencent generates. There is no benefit of looking at the incredibly high ROIC (well into the triple digits) that something like WeChat generates if those returns get overly diluted by poor investment decisions and bad allocation of free cash flow resources.

      So that’s my logic, but yes, most people would probably categorize some of those line items as excess capital that the business doesn’t require, and that’s probably true.

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