Tencent Is At A Crossroads And Will Possibly Be Forced To Take The Wrong Path

Written by Summary

Tencent’s brilliant capital allocation business could be disrupted by regulations.

The company recently sold its stakes in JD.com and Sea Limited.

Capital allocation is the biggest edge Tencent has over other big tech mega caps.

Editor’s note: Seeking Alpha is proud to welcome Stock Metal Investment as a new contributor. It’s easy to become a Seeking Alpha contributor and earn money for your best investment ideas. Active contributors also get free access to SA Premium. Click here to find out more » Nikada/iStock Unreleased via Getty Images In this analysis I will explain why Tencent Holdings ( OTCPK:TCEHY ) might no longer be the company that it was a year ago. I’ve been following Tencent for over one and a half years now, and I decided to sell my 8% position because I see its capital allocation business being crippled going forward. Tencent had an extraordinary business with many wide moats – or at least that was the case in the past. The regulatory environment in China has been very interesting over the last year and I am of the opinion that the CCP is eroding Tencent’s moat in some of their segments. An overview of Tencent’s business segments

First off, let’s quickly introduce the different segments of Tencent’s operation. The business is split into four parts: Value Added Services (52% of Q3 revenue/75.2 billion RMB)

Online Advertising (15.8% of Q3 revenue/22.5 billion RMB)

FinTech and business Services (30% of Q3 revenue/43.3 billion RMB)

Others (<1% of Q3 revenue/1.4 billion RMB)

VAS includes the Social Networks, namely WeChat with over 1.2 billion MAU and QQ with 574 million MAU, and their domestic and international games. The WeChat App especially has a wide moat. The lives of hundreds of millions of Chinese people center around this app. A lot of their other services are integrated into WeChat, and their miniPrograms (basically mini-apps inside of the app) in particular enjoy vast and rising popularity and profitability.

VAS also includes their gaming segment, which has been hit by regulations. The government has put harsh regulations on the amount of time children are able to play video games for each week. This regulation doesn’t impact the topline a lot, because the vast majority of domestic gaming revenue comes from adults. Nevertheless, it is an unfavorable development and in line with my thesis of an eroding moat.

Their Online Advertising business is leveraging their Social Media platforms to sell personalized advertisement space. One of the big bidders for this business used to be the online education sector. With the crackdown on the entire sector in 2021 and with the CCP basically declaring parts of their business model as non-profit from now on, the bidding from this customer group slowed down dramatically. Once again, these are declines in revenue primarily due to regulatory actions.

The FinTech and Business Services segment includes the WeChatPay fintech, which serves hundreds of millions of people and businesses alike. The business services here includes the Tencent Cloud offering, with many different services like IaaS, PaaS, SaaS (like their Tencent QiDian CRM), and more. Aside from that, they also are offering business software similar to the Microsoft Office suite with services like videoconferencing software. Although the cloud has an enormous runway ahead of it, I am concerned that selling to businesses outside China will be difficult and thus restricting the TAM for this still gigantic opportunity. Tencent’s rival Alibaba (NYSE: BABA ) took a hit from exactly that in their last Q4 : Slower revenue growth during the March quarter was primarily due to revenue decline from a top cloud customer in the internet industry, which decided to terminate the relationship with respect to their international business due to non-product related requirements. Capital allocation as the differentiator

Now that we’ve talked about their three main lines of business, I want to talk about their biggest edge over other Mega Caps: Capital allocation and Investing. Mega-cap Net Cash to Market cap (my own excel sheet) (Author) In the table above we can see that all of the Mega Caps and Chinese Big Tech companies have substantial cash reserves currently, with the exception of two companies: Tencent and Amazon (NASDAQ: AMZN ). All of these businesses have great cash flow generative operating businesses, but can’t reinvest their profits effectively. As an example, Alphabet (NASDAQ: GOOG ) spent $50 billion on share buybacks in 2021 and still has $111 billion in cash, earning 0%-1% interest. If only half of that money could be effectively […]

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