Assuming that you're OK with the geopolitical risk of investing in Chinese stocks, there are bargains abounding in the country's tech sector. After more than a year of Beijing's crackdown on what it deemed the "reckless" growth in Chinese tech stocks, valuations have come way down. The large Chinese property sector bubble also burst last year, and the associated economic headwinds are taking their toll on growth.
Perhaps the highest-quality Chinese tech stock is Tencent (TCEHY -0.94%) which sold off after its recent earnings report. Revenue growth slowed to just 8% last quarter, its first single-digit quarterly growth figure in its history as a public company.
Uncertainty across Tencent's businesses, from gaming to social media to fintech, is causing investors to avoid the stock now. But there are good reasons to believe the negative near-term trends will reverse later in 2022 -- notably, in three different ways. If they do, then Tencent sure looks like a bargain.
Game approvals could start back up
In the fourth quarter, Tencent's gaming business slowed down mightily. However, that was almost completely due to regulations that came down in August and September of last year, just before the fourth quarter started.
Domestic gaming grew only 1% last quarter to 29.6 billion yuan, making up 23% of Tencent's overall revenue. Certainly, as the largest publisher of games in China, and with growth coming down so much from its past pace, investors may be getting worried that the gaming industry has reached a "new normal." But this slowdown was inevitable. Starting Sept. 1, Chinese authorities banned minors from playing video games on weeknights, while limiting them only to one hour per day on the weekends. The ban had the expected result on Tencent's numbers. Gross gaming receipts from minors declined by 73%, contributing to 1.5% of total domestic gaming receipts.
But regulations went beyond this point, as Beijing slowed down all new game approvals in September as well. That had the effect of delaying the publishing of new games, of which Tencent management said the company had several ready and waiting for approval. Management expects new game approvals to restart sometime this year, although it didn't know when.
For those who think this situation marks a new baseline in China's gaming growth, that may be premature. As Chief Strategy Officer James Mitchell said on the conference call with analysts:
[I]f you refer back to the 2018 period, there was similar deceleration in game industry growth in China for comparable reasons. And at that time, there was a great deal of discussion around new normals and ex-growth and so on and so forth. And, of course, over the next couple of years, as new games came to market, those fears and concerns moved into the background. And I think that that's the situation we're in now. The game industry is actually the youngest. It's the most vigorous and it's the most well positioned to benefit from technology change of all the entertainment industries, and the entertainment itself is a superset of industries that are generally growing faster than GDP growth due to the satisfaction of Maslow's Hierarchy of Needs. So our belief is that the China economy will grow rapidly over time.
While domestic gaming growth may remain low this year, Tencent will be lapping the onset of these bans late in the third quarter of this year. Once it does, its growth figures should normalize or improve. And if game approvals commence sometime this year, growth will improve even more.
It should also be noted that Tencent's international games segment continued robust growth, up 34% to 13.2 billion yuan, or a little less than half of the size of the domestic games segment. Those sales are clearly unaffected by Chinese regulations, and they show continued strength of the global games business overall. In December, Tencent established its international publishing company, called Level Infinite, with offices in Singapore and Amsterdam. So it's clearly looking to grow its games aggressively outside China.
Image source: Getty Images.
Advertising revenue declined but will have easier comparisons
Beyond the tepid growth in domestic games revenue, advertising revenue declined -- not just in the traditional media segments, which were down 25%, but even in the powerful segment of WeChat social media advertising, which was down 10%, leading to an overall online advertising decline of 13%.
The drop in ad revenue is unsurprising, given that China's regulatory crackdowns have hurt several entire domestic industries. First and foremost is the for-profit education segment, which was decimated by regulations last summer. In the fourth quarter, online education decreased from a low-teens percentage of online ads to a low single-digit number, which Tencent management said explained basically all of the decline from a year ago. In addition, further new regulations regarding ad loads, advertising to seniors and minors, and data privacy also affected digital ads. And of course gaming ads were down as the aforementioned approvals pause took its toll.
The new regulations are definitely taking a bite today, but as Tencent laps the onset of the regulations this year, growth should again normalize. And although overall costs per ads were down and several industries pulled back, the total number of WeChat advertisers grew 30% year over year, and WeChat continued to add to its user base of 1.26 billion. So it is not as if WeChat is losing its competitive position.
Cloud services aren't even profitable yet
Tencent's fintech and cloud segment was the only one to post revenue growth within throwing distance of pre-crackdown rates, up a solid 25% year over year. However, what may have gone unnoticed is that Tencent's growing infrastructure, platform, and software-as-a-service business (SaaS) is not only less profitable than other segments but is actually loss-making today. CSO Mitchell elaborated:
And overall, what you've seen is that the cloud business, including IaaS [infrastructure as a service] and PaaS [platform as a service], is not just margin diluted, right? It's actually registering net loss, and also for SaaS, it's incurring costs, but not having any significant revenue, right? So these are actually loss-making businesses. But over time, you can actually improve the margin profile of the cloud business. And at the same time, you can start monetizing on the SaaS; then [the] margin profile of these businesses would start to improve.
Obviously, large and global cloud software businesses from the U.S. and Europe are quite profitable. Over time, as Tencent begins to monetize software and rationalize the costs of the other cloud services, its margins should grow accordingly. I think this could be a big business one day, but this segment is hurting profitability at present.
The next few quarters will be underwhelming, but Tencent looks cheap
Even with the final half of 2021 hammered by regulations, Tencent still made adjusted (non-IFRS) net income of $19.5 billion last year -- not counting any of its portfolio divestments -- which was roughly flat with 2020.
As of Friday, Tencent had a market cap of $444 billion, and its investment portfolio totaled $154 billion at Dec. 31. That portfolio went down in value, but assuming $144 billion for an even $300 billion market cap outside its investment portfolio, Tencent is trading at only around 15 times its core business earnings.
In the past month, Chinese officials have pledged to support growth this year following the regulatory crackdown last year, and it also indicated that the tech crackdown may be nearing an end, or at least that its peak may have passed.
Assuming the past year was one-time "reset," Tencent should begin growing again in the second part of 2022. If that's the case, its stock is a bargain.
