Once a darling among investors, Tencent Holdings Limited (TCEHY 3.23%) has seen enormous selling pressure lately. The Chinese government crackdown on tech companies, the weaker economy, and reduction by its major shareholder Prosus are a few factors driving its share price lower.
Contrarian investors, on the other hand, are taking this opportunity to buy the stock cheaply. But before you load up on the shares of this fallen angel, you should learn these two aspects about it.
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An understanding of Tencent's economic model
While many investors have heard about Tencent, few have understood its business model. So let's start by breaking down the company into a few significant aspects.
The first and probably the most crucial part of its business is social media networking, consisting mainly of Wechat and QQ. The focus of this business is to attract and retain Chinese netizens. To this end, Tencent's early-mover advantage, scale, and network effects give it a significant leg up against its competitors.
To make its social media app more appealing to users, Tencent offers additional services (on top of its communication function) to keep the users coming back. And that brings us to the second component of Tencent's business, which focuses on user retention and monetization through its "super app" model.
By innovating and introducing new services over time -- gaming, payments, online video, short video, e-commerce, music, and more -- Tencent makes its app indispensable to Chinese users. Its "super app" model improves user stickiness and opens new avenues to make money. Over time, these captive business units grew so big that they became separate companies that went beyond serving Tencent's ecosystem. For example, Tencent Tenpay is one of two leading digital wallets in China, and Tencent Video is a leader in online video.
Another vital element of Tencent's business model is partnerships. Here, Tencent partners with the best companies in different sectors -- Meituan in online food, Pinduoduo in e-commerce, Waterdrop in online insurance, and more -- to grow its ecosystem. Generally, the model here is that Tencent will provide access to its 1.3 billion-user base and financial resources in return for financial stakes in these partners.
With so many different components working together, it is not surprising that the tech conglomerate has a diversified revenue base. In 2021, 52% of Tencent's revenue came from value-added services (gaming, social media, and other entertainment), 31% from fintech and business services, 16% from online advertising, and the remaining 1% from other businesses.
What to expect from Tencent in the years to come
Tencent has amassed a remarkable track record of growth over the last two decades. Since its IPO in 2004, it grew top and bottom lines by a compound annual growth rate of 44%.
Its track record, however, has been interrupted lately amid a series of challenges. These challenges include the crackdown by the Chinese government and the slowdown in industries like online learning. As a result, revenue fell by 3%, and net profit plunged 55% in the second quarter of 2022.
Bulls and bears debate on whether Tencent's growth days are behind us. The former think that the slowdown is temporary, and Tencent will be back to its old days of high growth rate soon. The latter believe that the tech company has passed its prime and that its good old days of consistent growth are over.
I think it's too early to proclaim that Tencent's growth days are over. After all, there are still plenty of opportunities for the company to grow, be it in gaming, advertising, fintech, or others. With a population of 1.4 billion, China's demand for digital products and services will only grow over time. I err toward the bullish view that the current slowdown is more likely to be temporary than permanent.
Still, I don't think Tencent can sustain its historically high growth rates. One reason is that the Chinese government has communicated clearly that the way forward is shared prosperity. In simple language, companies cannot exercise their privileged position to generate outsize profitability. While I don't see Tencent's competitive advantages weakening, the government's new direction will likely impair its profitability and growth prospects.
Fortunately, Tencent has another avenue to keep growing, and that's through its investments. As one of the best tech investors -- having invested in companies like Meituan, Sea Ltd, JD, Pinduoduo, and EPIC Games -- Tencent has the skills and the resources it requires to allocate capital. Here, the company can invest almost anywhere in the world and in the best companies across the whole technology spectrum. It can acquire significant stakes in related industries like gaming or buy minority stakes in publicly listed companies -- it has invested in Tesla, Snap, and others in the past.
Long story short, I think Tencent will resume its growth mode -- albeit at a lower rate -- in its operating business. The company will likely redirect the excess capital into external investments to create shareholder value.
