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Introduction
Given the growth rate and scale of China’s economy, it wouldn’t be too farfetched to envision a future where the largest Chinese companies could rival the size of the US mega caps.
Currently, the largest Chinese tech company by market cap is Tencent. Its market cap stands at US$770bn, with an annual revenue of US$74bn and net profit of US$25bn in 2020.
For context, Tencent’s market cap is still only:
- One-third the size of Apple’s (FY2020: revenue of US$275bn and net profit of US$57bn)
- Less than half the size of Amazon’s (FY2020: revenue of US$386bn and net profit of US$21bn)
For investors who are keen to get long-term exposure to Tencent, we discuss why buying into Prosus (Tencent’s largest shareholder) is currently preferred in our view, compared to buying Tencent directly.
Disclaimer: We have personally bought into Prosus on 3 May 2021.
Article Summary
1) Prosus as a proxy for Tencent
2) Prosus’ historical discount to its stake in Tencent
3) Prosus’ financials and valuation
4) Analyst ratings and target prices for Prosus
Appendix 1: What does Tencent own?
Appendix 2: Tencent’s financials and stock valuations
1) Prosus as a proxy for Tencent
Prosus is Europe’s largest consumer internet company. The stock’s value is mainly derived from the stakes it holds in other internet companies. The image below shows what Prosus has invested in, as of Mar 2020. The single most valuable investment holding would be its stake in Tencent (Prosus is Tencent’s largest shareholder), which comprises about 80% of the total value of underlying investments held by Prosus.
Its other underlying investments are geared towards consumer tech within emerging markets.
An investment in Prosus should theoretically be a good proxy for Tencent. However, with Prosus underperforming Tencent by a massive 30% since the start of 2020 (chart below), we wondered if this has opened an opportunity for a relative value trade, which we will discuss in the next section.
2) Prosus’ historical discount to its stake in Tencent
As a holding company, Prosus should trade at a discount to the sum of its underlying investments. Some investors would refer to this as a “conglomerate discount”. We will look at what this discount has been historically, and whether the current discount is wider than usual, which might make Prosus a relatively more attractive investment.
First, we plotted the Enterprise Value of Prosus since its IPO in Sept-2019, against the value of its 31% stake in Tencent (chart below). We observe that Prosus’ Enterprise Value has been trading at a discount to the value of the underlying Tencent stake, and this discount has widened in the past year.
Next, we plotted the discount that Prosus has been trading since its IPO, relative to its stake in Tencent (chart below).
The current discount of 28% is meaningfully wider than the historical average discount of 22%, and closing in to past instances where the discount had been at its widest (indicated by the blue dots).
Apart from Tencent, recall that Prosus also owns stakes in a number of other internet companies. If you factor in the market value of these other internet companies, the current discount would be even wider at around ~35%.
Should there be a holding company discount?
Yes, a holding company discount is warranted but the key question is how much. Given that Prosus owns such a large stake in Tencent, it would be difficult to liquidate the position without a negative price impact on Tencent. Previously, partial divestments of its Tencent stake were executed at a discount to Tencent’s market price. For example:
- In March 2018, Prosus’ parent Naspers divested a 2% stake in Tencent at a 7.8% discount to Tencent’s share price.
- In April 2021, Prosus divested a 2% stake in Tencent at a 5.5% discount to Tencent’s share price.
Personally, we view the results of the recent divestment positively. The indicative range of the Tencent block trade had originally been set at between HKD 575 and HKD 595. Investor demand had been strong enough for the block trade to be eventually priced at the top of that range at HKD 595, a 5.5% discount to Tencent’s share price (which is a narrower discount compared to the block trade executed in 2018).
In addition, Tencent’s share price has managed to remain above the psychological level of HKD 600, after the block trade was completed, indicating that investor sentiment has generally been positive. In contrast, Tencent’s share price had plunged by 45%, in the half-year period after Nasper’s partial divestment in 2018. Since the stock price didn’t even fall to the block-trade price this time around, it seems to signal that investor sentiment has become significantly more buoyant.
Note that Prosus does not have to pay any capital gains tax on its Tencent divestment, so we won’t have to factor that into the holding company discount.
Prosus had recently disclosed no plans to divest more Tencent shares in the next three years. Divestments are important catalysts for narrowing conglomerate discounts, so the absence of this in the near-term is on our minds. However, given that the discount has widened to such an extent, we do see the potential for Prosus to trade higher as investors look towards Tencent’s longer-term potential.
3) Prosus’ financials and valuations
We list Prosus’ net income in the below chart, with consensus estimates for FY 2021 to FY 2023. It’s less useful to look at Prosus’ revenues or operating profits, as the contribution from its Tencent stake would not be reflected there, and only shows up in net income figures.
This is similar to how most companies would account for associate stakes (see here for example).
Tech sector earnings have generally been boosted by Covid lockdown measures. For Prosus, the company’s net income is expected to more than double from FY 2020 levels, by 2022.
As a result, Prosus currently trades at a forward P/E of 25.8x, which is inexpensive compared to its historical average of 34.6x (chart below).
In addition, factoring in the expected earnings growth for 2022-2023 would imply a P/E in the low 20x range!
4) Analyst ratings and target prices for Prosus
We have compiled the latest analyst ratings and price targets for Prosus in the table below.
Sentiment for Prosus is bullish, more so than Tencent in fact (we also compiled the analyst target prices and ratings for Tencent, which may be found in Appendix 2).
The median target price for Prosus is EUR 127.50, implying a 42% upside from its closing price of EUR 89.82 on 30 Apr 2021.
The InvestQuest View:
For investors who are keen to get long-term exposure to Tencent, buying Prosus (Tencent’s largest shareholder) is currently preferred in our view, compared to buying Tencent directly. We see upside to the stock given a positive view on Tencent, a potential narrowing of Prosus’ holding company discount, and potential growth opportunities across its other EM tech-related investment holdings.
Appendix 1: What does Tencent own?
Many people have heard of Tencent, China’s largest Tech company. If you haven’t, perhaps you would have heard of some of its applications and subsidiaries, and to name a few:
- WeChat and QQ
- Supercell (mobile game developer for Clash of Clans, Brawl Stars, Clash Royale etc.)
- Riot Games (game developer for League of Legends)
- Tencent Music Entertainment
- China Literature
- Tencent Cloud Computing
Less known to many is that Tencent also has a number of equity investments within the tech space, including but not exclusive to stakes in the following companies (rounded to nearest percentage point). We include the market value of these holdings in brackets.
- 18% stake in Meituan Dianping (US$44bn)
- 26% stake in Sea Limited (US$35b)
- 17% stake in Pinduoduo (US$28bn)
- 18% stake in Kuaishou (US$26bn)
- 18% stake in JD.com (US$22bn)
- 16% stake in Nio (US$11bn)
- 11% stake in Snapchat (US$10.5bn)
- 16% stake in Bilibili (US$7bn)
- 12% stake in KE Holdings (US$7bn)
- 30% stake in Futu Holdings (US$6.5bn)
- 10% stake in Spotify (US$5bn)
- 0.5% stake in Tesla (US$3bn)
- 37% stake in EPIC Games, the game developer of Fortnight
Appendix 2: Tencent’s financials and stock valuations
In this section, we offer a bird’s eye view of Tencent’s:
- Historical revenues, and analyst consensus estimates for 2021 to 2023
- Historical net income, and analyst consensus estimates for 2021 to 2023
- Forward P/E, from 2016 to current
- Analyst ratings and target prices
Tencent’s Revenues
In the below chart, we show Tencent’s annual revenues by segment, which has grown by 35% p.a. from 2016-2020. Analysts are currently modelling a more conservative growth projection of 20% p.a. over the next three years.
A commonly cited operational metric is the monthly active users for WeChat and Weixin, which we have included in the image below.
WeChat has become the social app of choice in China, with 78% of people in China aged 16-64 using it (source). As a result of the already high penetration rate, user growth has started to taper off. Moving forward, Tencent will have to focus on how to optimally monetize its current user base and develop new engines of growth.
Tencent’s Net Profits
Tech was one of the sectors that many deem to have benefitted from Covid lockdowns. It seems like Tencent was no exception, with net income in 2020 growing over 70% year-on-year.
In the below chart, we show Tencent’s net income, from 2011 to 2023F. The spike in net income margins in 2020 looks more like a one-off and analysts are projecting for margins to normalize closer to historical levels in the years ahead, with net income growth expectations of 12% p.a. between 2020 and 2023.
Tencent’s Forward Price-to-Earnings
Tencent currently trades at an inexpensive forward P/E of 33x, close to the historical average of 34.5x.
In a bear case scenario, we see a potential downside of 20% (implying a stock price of HKD 500), if we assume that Tencent trades back down to its P/E trough of 26x.
Analyst ratings and target prices
We compiled analyst ratings and target prices (table below), which have been reviewed in April 2021 or after.
Analysts are generally bullish with a consensus price target of HKD 780, implying 25% upside to Tencent’s share price of HKD 623 (as of 30 Apr 2021 market close).
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