Mark Ingham: Tencent hits it out the park, but have doubts around Naspers

A pedestrian walks past Tencent Holdings Ltd.’s Photographer: Qilai Shen/Bloomberg

LONDON — Chinese internet giant Tencent hit analyst forecasts out the park last week when reporting 40% plus growth in all its major segments. Independent investment analyst Mark Ingham takes a close look at the financials and makes a case for even further improvement in its share price. But he is among those who are sceptical about the group’s biggest shareholder, South Africa’s Naspers, whose share price has de-linked from Tencent’s in recent times and now trades at a 26% discount to the value of that holding alone. My view on Naspers is somewhat different, as you’ll pick up in this interview. For me the stock is poorly understood by analysts and being offered at a massive discount, is a screaming buy. But that’s what makes a market. – Alec Hogg

This special podcast is brought to you by EasyEquities, and independent investment analyst Mark Ingham joins us from Johannesburg, where he’s been keeping an eye on Tencent, as I guess so is the rest of the world. Mark, this has been a phenomenal company and of course a big SA interest due to the stake held by Naspers.

Yes, and it’s the gift that keeps on giving, I think Alec. The outlook for the foreseeable future looks pretty good. They’ve just recently had their Q2 (second quarter) results, as you’ll be well aware. Very strong results. In fact, I think ahead of what many analysts had pencilled in. I, in fact, have just raised my share number for the full year.

Well their results came out as you say, Q2 they came out last week. Blew away projections, ¥56bn in revenues for the quarter, which was a lot higher than anticipated. Maybe if you can just explain though, for the uninitiated. They might own Naspers shares and think that’s a media company but in fact, the Tencent business is a lot different to what we see in Naspers.

A logo of Naspers Ltd. sits on the side of the headquarters of the Media24 Ltd. building in Cape Town, South Africa. Photographer: Graeme Williams/Bloomberg

Yes, it is there are a few moving parts and if we just break it down on a revenue basis we’re looking at a business that includes a number of pretty good businesses. Social networking is included. They’ve got an online games business. In fact, online games is probably the largest component piece of the Tencent revenue. It will be approximately 40% of revenue this year, and followed by social networking, which is just over 20%, and then online ads. Then there’s various other bits and pieces that make up the balancing item.

The growth numbers look pretty good. You’ll be looking at 45% – 50% net revenue growth this year. Social networking is growing at probably 40%. Online games growing at over 30% and the ad business growing at a rate of 40% or so. Then the smaller pieces are growing off a much lower base, that’s payments and cloud revenue, rising quite sharply, in triple numbers, so 170-odd percent, I think, increase in the latest results.

Then I think if we unpack the profit number too, you look at a fairly similar picture for the group and all of these operations that they have are comfortably profitable. There are a few in developmental stage but it will mean that the business this year, from an operating profit point of view, will probably make about ¥70-odd billion. Then if we look at it on a non-GATE basis, which is adjusting for various ephyras items, you’re looking at a bottom line of about ¥60b, which is a huge number.

The numbers are just too big to even comprehend but maybe what puts it into perspective is that if you take the number of active users that Tencent has. There’s only company in the world that has more and that’s Facebook. I saw an analysis that if you add them up it comes to 2.4b people who use Tencent. I don’t know if that penny has dropped amongst South Africans, who still don’t understand that buying into Naspers means that you’re buying 1/3rd effectively, of this enormous company that is just mushrooming.

Well that’s it. If you take QQ active user accounts, it’s about 850 million. If you take QQ paying accounts that’s over 100 million. If you look at revenue numbers and if you look at WeChat the numbers run into the 100’s of millions. Of course, they’re playing in a country with the world’s biggest number of people. The population is whatever it is, 1.4 or 1.5 billion and there’s an insatiable appetite for the type of products they have.

If I just think of this last set of results. You look at a game, and I’m no gamer, but if you take Honour of Kings. You have Q2 mobile gain revenue growing at 50%, give or take, year on year, and that was driven by an existing title, which is called Honour of Kings. Then you’ve got new titles and I don’t pretend to be an expert by any stretch in these things but Dragon’s Nest and Legacy so, these games are finding favour. They’ve got huge billings. They’ve even got sports related stuff, all sorts of different categories so, it’s a multifaceted beast that we’re dealing here with.

Yes, and those numbers of people that are using it, and the revenues, etcetera are just difficult. To talk about 850 million people using QQ. That’s almost the whole population of Africa, just to kind of put it into perspective. What if this were a US company, let’s just use that as an example, because clearly the American investors know Facebook, Google, and Amazon a lot better. Do you think the rating would have been much higher?

I’m not sure. I think the rating is deservingly rich. You’re looking at a business on a PE of probably 40 odd. But your earnings are growing at that rate so, if you looked at the business on a price earnings to growth ratio, let’s say, looking over a 3-year period. You’ve got a business that’s trading on a premium multiple, but you’ve also got a business that’s growing its earnings at one hell of a clip. From a price earnings to a growth multiple point of view you could argue that the stock is pricey, at a PE of over 40 but, as I say, if your earnings are growing at 40% it means your price earnings to growth ratio is one, so it isn’t quite as expensive as it appears at face value.

Explain that. What is a price earnings to growth ratio?

Well, it’s a function of your PE in relation to your earnings growth so, let’s put it simply. If my PE is 10 and my earnings over a 3-year compound growth expectation are growing at 10. It means I’ve got a 1.0 PEG ratio, which means my PE is in line with the earnings growth.

Okay, got it. We brought this into our global portfolio over the month of May, June, and July, and we averaged out at a price of R289. It is up 13.5% since then, which is very nice. It is R328 at the moment. Do you think there’s still value in this share at this level?

Yes, people thought the stock was expensive at below R200, and ‘kyk hoe lyk ons nou?’ So, the share price has been pretty much keeping track with the earnings growth and I think your entry level price was certainly well timed. The growth in this last year has been phenomenal. In fact, to go back to December also, you could buy this at R180 odd. Now you’re paying R328. As I say, you’re buying a business that’s growing its earnings at a phenomenal rate so, we can look forward to earnings growth this year of well over 30%, close to 40%. I think in fact, what we’re seeing at the moment is that analysts, who tend to be quite cautious on the momentum, I think it always pays to be cautious on the degree to which any company can keep up what has been a historically high rate of earnings growth but you reach a certain cruising altitude and I think you build that into your forecast modelling. But each time Tencent seems to confound any doubt in Thomas’ and as a consequence that’s why you tended to see earnings being upgraded on an ongoing basis and I think, and I put out a note to my clients around the results and I compared them to what I had forecast, which was pretty generous to what they actually came out with. I had to say, look guys, I’m going to have to up the figures. The run rate this year is such, we take the first 6 months, is such that I’m going to have to add about an 8% increment to my EPS number, which is what I’ve actually done. I think given the innovation that we’re seeing coming out of this company. Given the fact that they’re very close to their market. I think they’re quite sensitive of course, to recent rumblings from the Chinese authorities about the social effects that some of these games are having. There’s the cyberspace investigation in China, the cyberspace administration investigation are on the go and the Chinese government have accused a number of these gaming companies of fuelling gaming addiction amongst youngsters, which has other social consequences.

I think it’s quite interesting that with that in mind, the company, or the chairman in fact, commented in this last set of results that they stepped up their effort to ensure users play games in what they call a healthy manner. I’m not sure how you play these games in a healthy manner but clearly, I think they are trying to address some of these concerns. I don’t see that however, derailing the progress of growth because as I’ve said, they have got a number of drivers to their revenue. They’re not just a one trick pony so, you’re seeing good growth outside of the online games. For instance, if you go back a few years online games was 55% – 60% of total revenue. I reckon that’s going to drop to probably 35% by 2019, but commensurately you will see a greater share coming from the other revenue components of the business.

Just to close off with. Naspers, the biggest stock on the JSE, or local stock on the JSE has traded at a discount, a significant one at that, to its holding in Tencent. How do you view that? Do you view that as a cheap way into Tencent by buying Naspers or do you believe that discount is there, locked in?

Let’s break down the PNL. If you look at the EBITDA that Naspers reported for this year, which was about $3.25bn, but of that Tencent contributed roughly, $3.3bn. The total Naspers consolidated EBITDA was about $72m. There is no doubt that Tencent share of reported EBITDA is approximately 100%. Then if you go down to the earnings line Naspers reported earnings growth as 40% in Dollars, up to $1.75bn, that’s at the core earnings level. You would say at first glance, wow, that’s terrific these Naspers guys are doing a great job. Then if you back out the Tencent contribution from that, it’s about $2.2bn, which means that the Tencent share of the earnings is approximately 130%. Therefore, the Naspers losses on a consolidated basis, in aggregate, and that would include the very profitable MultiChoice. Multi-Choice SA made approximately $860m in EBITDA so, it’s more of an old economy business, if you will. But that business, together with the dividend of something in the region of $240m from Tencent. Those 2 component pieces are the cash cows of Naspers but allows it to spend on developmental areas. The Naspers losses are something in the order of $500m if you back out Tencent, and that includes the profitability that comes from MultiChoice.

But is it a fair way of looking at it? This is a company that’s making some huge bets. If you look at Flipkart in India, where they’ve invested billions and billions and alongside eBay, alongside Tencent, alongside Microsoft and then Delivery Hero in Germany and those are just recent ones, Mail RU. It seems a bit strange. It’s an investment company and yet we’re judging them on their earnings.

Yes, but we’re looking here at cash earnings and we’re seeing a haemorrhage of cash. The losses have actually accelerated in the last number of years so, yes, they are spending a lot of money and if we just take the developmental spend you go, just in the last few years, it’s now reaching a level of about $800m, and could probably go to as high as a billion in the coming year or two. There’s no evidence to date that the money that they’re spending on these developmental assets are actually contributing in any meaningful way to the cash that’s been generated and to the earnings that have been reported. I think there is a sense that the large discount that you refer to, to the Tencent valuation, which has been up to 30% of late. If I just look at my model, it’s about 26% on the see-through value of its stake in Tencent. Over the last 4 or 5 years has been a trend to where people valued these developmental assets at a premium. So, when you were buying Naspers a few years ago you were actually buying it at a premium to the value of Tencent. That steadily degraded to zero and has now increased to record levels. It’s coincided with growing developmental spend and as yet, elusive returns.

A logo sits on display inside the headquarters of Naspers Ltd., at the Media24 Ltd. office complex in Cape Town, South Africa. Photographer: Halden Krog/Bloomberg

Well, every market has got two different perspectives. We’ve been listening to Mark’s perspective on Naspers and there is the other side of the coin, which says that you have to invest heavily in these developmental assets in that period. That’s what Naspers are betting on. They better bring home the bacon, in no uncertain terms, is what you’re saying. Those assets have, at some point in time, have got to start delivering. Otherwise the market or certainly those who are analysing Naspers’ share price, at the moment, would be saying they’re going to be destroying value.

Well, yes. In the 6 years, if you go back to 2016, in those 6 years about $3bN was spent, and in the coming 5 years, 2017 – 2021, somewhere around there, you’re looking at potentially $1.5bn – $2bn being spent, potentially. Maybe even more, we’re not quite sure. If you look at that over a 10 – 11-year period, that would be $5bn, which is a significant amount of money in anybody’s language, or you average it out at $450m a year over that period and it starts to become a large number. It means you’ve got to start generating some pretty serious EBITDA, and quite shortly to justify that spend. They have realised some assets, and they’ve realised some assets at quite a handsome price. I think in the last year or so it was something like $3b. I think there is evidence that some of the assets that they have acquired in recent times have in fact, done quite well from a return point of view. What seems to be the case is that they will be redeploying some of the cash that they’ve realised from selling assets into reinvestment in other areas. I think there is some concern that the money that they realised from the sale of assets may well go to be redeployed potentially, into assets that may actually absorb cash, and potentially destroy value. I think there are a number of schools of thoughts at the moment. There’s the bullish school of thought, and I think you fall into that camp that they’ve got a number of buckets that they’re invested in and if only a handful of those start to come through then the doubters will be put firmly in their place. You’ve got those who have to perhaps be a little more sceptic. I’m a financial guy and, therefore, I’m saying to myself there’s a lot of money being spent. As yet, we’re not quite yet seeing those returns. You can build a certain blue-sky element into your model and ‘ve done that to a certain extent. I have assumed that, as the years go by, a number of these assets will start to realise returns. Pacify us for instance, Flipkart, Make My Trip, iFood, Delivery Hero – you can certainly model a scenario where those really start to add to the value of the business, the so-called Naspers rump outside of Tencent. In fact, the biggest component of that at the moment, from a valuation point of view, is pay-TV and I have a fairly sizeable value associated with that but as yet, I’ve attributed a relatively small number to the eCommerce assets at this stage.

Well, it’s as we said before, you have the insight there from independent analyst, Mark Ingham, and this special podcast was brought to you by EasyEquities.