Tencent (OTC:TCEHY) stock tumbled 24% in 2018 as a nine-month freeze on new gaming approvals hurt its gaming business and concerns about China's economic health spooked investors. However, it rallied about 20% this year as value-seeking investors scooped up beaten-down Chinese stocks.

Tencent also thinks that its stock is undervalued, since it recently proposed to repurchase 10% of its outstanding shares over an undetermined time frame. That plan, which is worth about $44 billion as of this writing, could "spur a rally," according to Zhongtai International Securities analyst Norman Hui. Shareholders will need to approve the plan during its annual meeting on May 15.

A bespectacled man in a dark suit throwing cash at the camera.

Image source: Getty Images.

Shifting from investments to buybacks

Tencent generally doesn't spend a lot of money on dividends or buybacks. Its stock pays a paltry forward yield of 0.2%, and its last major buyback (last September) was worth just 887 million Hong Kong dollars ($113 million).

Instead, it usually favors investments -- in its own business units and other companies -- to expand its ecosystem. However, the bears claim that Tencent's scattershot investment strategy lacks focus, and that it often chases hot companies at premium valuations. These investments also produce big gaps between its reported (GAAP) and adjusted (non-GAAP) earnings:

Metric

Q4 2017

Q1 2018

Q2 2018

Q3 2018

Q4 2018

Revenue

51%

48%

30%

24%

28%

GAAP net income

98%

61%

(2%)

30%

(32%)

Non-GAAP net income

42%

29%

20%

15%

13%

Year-over-year growth. Data source: Tencent quarterly reports.

Tencent's investment gains and losses are included in its GAAP profits but excluded from its non-GAAP profits. If we only look at non-GAAP profits, its earnings growth consistently decelerated over the past year, culminating in its biggest earnings miss in about a decade last quarter.

Many of Tencent's top investments, including JD.com, Snap, and Meituan Dianping, also struggled over the past 12 months. Because it also dominates multiple markets, it doesn't have that much more room to expand.

Tencent already owns China's top mobile messaging platform (WeChat/Weixin), the world's biggest gaming portfolio, and market-leading mobile payment and streaming video platforms. It owns a majority stake in Tencent Music, the country's top streaming music platform, and has a growing presence in the cloud platform and AI markets.

A young woman, set against a magenta background, listening to music through white headphones attached to her black smartphone.

Image source: Getty Images.

Tencent still competes against Alibaba (NYSE:BABA) in many of these markets, but its core growth strategy -- the proliferation of third-party Mini Programs inside WeChat -- isn't a capital-intensive one, because it merely hosts the apps for other companies.

Taking a cue from Alibaba

Alibaba announced a $6 billion buyback plan in 2017, but only started buying back shares last September. By the end of last quarter, it had bought back $1.57 billion in shares. Alibaba's buyback plan is more conservative than Tencent's, but it was executed for similar reasons -- it was sitting on extra cash and thought that its stock was undervalued after the sell-off in Chinese tech stocks.

Tencent's cash and equivalents declined 7% to 97.8 billion RMB ($14.6 billion) at the end of 2018. Its free cash flow (FCF) also fell 11% to 83.4 billion RMB ($12.4 billion) for the full year. However, those declines were mostly caused by aggressive investments and the aforementioned freeze on gaming approvals, which ended in December. The situation improved in the fourth quarter, when its FCF rose 18% annually to 28.6 billion RMB ($4.3 billion).

Those figures indicate that Tencent won't abruptly buy back 10% of its shares all at once. It could wait a year, as Alibaba did, before starting the buyback, or not buy back any shares at all -- since a buyback authorization merely clears the way for optional purchases.

Is Tencent's stock undervalued?

I'm a longtime Tencent investor, and I'm not sure a buyback is the right move at this moment. Its buyback last year, which stretched out over six weeks, was disastrous because it coincided with a huge drop in its stock price.

Tencent currently trades at about 33 times its average earnings estimate for 2019. That's a high valuation relative to its projected earnings growth rate of 15%, and a 10% reduction in its outstanding shares won't make it that much cheaper.

Instead of a buyback, I'd like to see a dividend hike. Tencent's tiny yield is barely worth mentioning today, but raising that payout would reward patient shareholders and possibly attract new investors. I think those who are bullish on Tencent's long-term prospects in the gaming, advertising, and social media markets should consider buying the stock at these levels -- but its big buyback plan doesn't necessarily indicate that its stock is cheap.