Tencent Holdings (TCEHY +1.24%) continues to have a rough 2018.
Amid international political controversy and stringent policy regulation in China, the Chinese technology conglomerate has fallen about 20% in 2018 against the backdrop of another strong year for US large cap technology companies. In the company's second quarter earnings report, Tencent posted its first ever profit decline, which sent shares down as much as 9% on the day. The drop in profit had to do with Chinese regulators failing to approve the release of some of Tencent's video game franchises, namely Dragon Hunter and Player Unknown Battlegrounds (PUBG).
While regulatory concerns over game monetization remain cloudy in the near term, Tencent's other business lines continue to grow and boast an incredible set of network effects.
IMAGE SOURCE: TENCENT
"The Widest Moat In History"
Tencent owns Chinese social networks WeChat and QQ, which have monthly active uses bases of 1 billion and 803 million respectively. Given the entire population of China is roughly 1.4 billion people, it's safe to say Tencent is a considerable part of the average Chinese consumer's life. Similar to Facebook (FB 8.49%), WeChat benefits from having a large user base for users to connect with and message friends and family, but unlike Facebook, these apps are nearly essential for life in China as they connect to e-commerce websites, process payments, handle online banking, and can even call a taxi.
Tencent has yet to monetize their social platforms and has been reluctant to sell advertising to the extent Facebook has, in fact, Facebook currently makes over 20 times as much revenue per user as Tencent. While gaming revenue only increased 6% year over year, online advertising grew 55%. However, the real sleeping bear in this ecosystem may be their payments platform which is growing at an astonishing 81%. A fair US comparison to Tencent's payments platform would be PayPal's (PYPL 1.57%) growing online payments platform. If payments continue to grow at the current rate, the segment will eclipse Tencent's gaming segment in 18 months.
Owning such a robust ecosystem of social media, gaming, and payment solutions in the worlds most populous country leads to a powerful network effect for Tencent. Instead of accessing content through IOS or Android operating systems, users connect to content directly through the WeChat platform. It's almost as if Tencent has taken some of the US's most powerful businesses -- Uber, Facebook, and Paypal -- and built it inside a platform that is reminiscent of Apple's (AAPL +0.30%) app store. For these reasons Morningstar analyst Matthew Coffina predicted Tencent could have the "widest moat in history," and I have to agree.
The Good and Bad of China
While Chinese regulators have sent Tencent stock spiraling down with bans on certain video games, the Chinese government also provides Tencent with competitive advantages. Foreign technology companies have had difficulties expanding into China, and often need to partner with Chinese companies to distribute their products in the country. Earlier this year, Spotify (SPOT +0.49%) and Tencent swapped equity to form a technological partnership. Epic Games, creator of the viral video game Fortnite, is 40% owned by Tencent, which gives Tencent access to popular intellectual property and gives Epic Games a runway into new markets. Instead of outright buying competitors, Tencent prefers to buy out stakes in companies, which they have done with popular companies like Tesla (TSLA +2.45%) and Snap (SNAP +1.09%) to both learn from the companies as well as hedge their bets away from more volatile Chinese markets.
Despite Chinese regulators restricting the sale of certain video games, the overall trend in China has been shifting to more democratic, open markets. China is known for operating monopoly like state-run businesses, so Tencent may be less subject to antitrust regulation than competing American technology companies. Broadly, the Chinese government wants it big tech players to succeed and compete internationally, so it's hard to imagine regulators holding Tencent down indefinitely. As the only major Chinese technology company actually listed in China, Tencent is a great source of national pride and wealth.
Buy Now?
Tencent is trading at it's lowest trailing P/E multiple since 2013, which I believe makes this recent drop a very attractive buying opportunity. While 35 times earnings may not be cheap, the company has logged a 44% 3-year compound annual revenue growth rate and boasts margins that could rival the strongest US Technology companies.
And the growth story isn't over -- Tencent has strong properties and plenty of room to grow in the coming years.
