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Is Tencent Stock a Buy?

By Nicholas Rossolillo – Oct 2, 2020 at 8:00AM

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The Chinese tech giant with a stake in viral video game Fortnite faces mounting political scrutiny.

Chinese tech companies have been getting hit with a wave of political scrutiny in the last few years. For tech titan Tencent Holdings (TCEHY -3.47%), its epic rise to power was put on pause in 2018 when Chinese regulators put applications for new games on hold, and clearing hurdles in a complex regulatory system in the country is a never-ending ordeal. 

But China's video game and social media giant is facing increased scrutiny away from its home turf as well. Purely looking at the financial picture, though, Tencent is worth owning -- though there are better buys out there at this minute.

A woman holding a smartphone and credit card.

Image source: Getty Images.

Regulators setting a speed limit

Tencent isn't alone in dealing with political issues. All over the world, big tech companies are facing all sorts of regulatory scrutiny, creating some headwinds to their continued expansion. Regulations could put a cap on Tencent's upside going forward.

Specifically, the company's WeChat social platform (a "super app" that combines messaging with e-commerce and digital payments, entertainment, and a myriad of other digital services) is facing scrutiny as it tries to expand beyond China. Tension between India and China over a long-standing border dispute led to India banning over 100 Chinese apps, including WeChat and the PUBG Mobile video game it is invested in. The Trump administration is also trying to shut down WeChat in the U.S., and scrutiny over Tencent's video game business -- which includes a stake in Epic Games, responsible for the global hit Fortnite -- is also on the rise.  

Granted, the vast majority of Tencent's revenue comes from China itself, so recent roadblocks aren't going to upend the tech empire. Nevertheless, with the screws tightening on Tencent outside of its home market, and complex regulations within China always a concern, a speed limit is being placed on Tencent's potential growth.

But what about the financials?

That being said, Tencent isn't green behind the ears. It's been navigating its way around political controversy and regulations for years and still finds ways to expand. And even if it's reduced to growing only in China, that's not a terrible place to be. E-commerce and digital payments -- especially in a post-COVID-19 world -- are still a high-growth industry on the other side of the Pacific, and Tencent has a virtual duopoly with its peer Alibaba (BABA -0.90%)

Illustrating how powerful of a platform it has become, Tencent reported having over 1.2 billion WeChat users at the end of June 2020. Revenue increased 29% year over year to 114.9 billion Chinese renminbi ($16.2 billion) during the second quarter of 2020. Operating profit increased 38% to 37.6 billion renminbi ($5.3 billion), and free cash flow (revenue less cash operating and capital expenses) increased 127% to 28.5 billion renminbi ($4.0 billion) -- adding to the company's impressive run.

TCEHY Revenue (TTM) Chart

Data by YCharts.

Tencent has amassed cash and short-term investments totaling 260.0 billion renminbi ($36.7 billion), although total debt tallied up to 259.3 billion renminbi ($36.6 billion) as of the end of June 2020. Alibaba by comparison has a net cash position totaling in the tens of billions (as measured in U.S. dollars).

Nevertheless, reflecting its impressive recent results, Tencent stock trades for a premium 32 times trailing 12-month free cash flow.  

Is it a buy?

Given its enduring growth even in challenging times, an investor could do far worse than buying Tencent right now, although I think Alibaba is the better choice with a larger war chest on hand and the stock trading for a close 37 times trailing 12-month free cash flow. If you think China's middle class and e-commerce industry will continue to develop, I'd start with Alibaba first, though Tencent should still make the short list. 

However, while I am a Tencent shareholder, I think there are more timely purchases at the moment. Southeast Asia's Sea Limited is a much smaller tech conglomerate putting up massive growth numbers. If Tencent continues to hit snags in its overseas ambitions, owning other e-commerce and video game stocks like Sea will be important for investors looking to bet on technology advancement in Asia.

Nicholas Rossolillo owns shares of Alibaba Group Holding Ltd. and Tencent Holdings. The Motley Fool owns shares of and recommends Alibaba Group Holding Ltd., Sea Limited, and Tencent Holdings. The Motley Fool has a disclosure policy.

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