Tencent Takes Aim Again: One, Two, Three, Who Will Freeze?

About three years ago, when the regulatory hammer to prevent the disorderly expansion of capital had just fallen for over half a year, Dolphin Jun analyzed the changing trend of the investment landscape of $TENCENT.HK from 2017 to 2021 and the underlying logical changes behind it ("Revisiting the 'half-life' value Tencent handed out").

Subsequently, when Tencent suddenly sold off JD.com and Sea, withdrew from the board of directors, and amidst the looming financial regulatory risks, concerns were raised again about the fundamental change in the logic of Tencent's investment assets and the risk of subsequent divestment faced by invested companies ("Tencent bids farewell to JD.com: a happy breakup or a painful parting?", "The butterfly effect of Ant Group: will Meituan and Pinduoduo be dumped by Tencent?").

When the unfortunate prediction about Meituan came true, suddenly all the risk warnings from invested companies were associated with Tencent's divestment. However, with the release of the 2023 financial report, Tencent seemed to have paused this "123 wooden puppet" game and repeatedly expressed confidence in the prospects of the listed companies it invested in, indicating that it would not easily sell off again.

But has everything really calmed down?

Originally, Dolphin Jun also believed that the asset sell-off might really come to an end, at least for a window of 1-3 years. The reason for this judgment was mainly based on Tencent's rapid decline in the number and scale of external investments starting from 2022. Selling without buying, although beneficial to small and medium shareholders in the short term, would also affect Tencent's long-term growth potential when the "half-life" function of the investment landscape was weakened.

However, after Tencent announced a billion-dollar buyback plan, Dolphin Jun believes that a new round of the wooden puppet game is about to unfold. This time, the divestment may not mainly take the form of physical dividends, but more likely to continuously sell off in the open market, aiming to exchange for real money to fill the funding gap required for the billion-dollar buyback + dividends. Therefore, the period of stock price pressure for invested companies will also be longer.

Therefore, Dolphin Jun believes that after three years, it is necessary to once again review Tencent's investment landscape, deduce Tencent's possible actions in the future, and timely pay attention to the risks related to the assets.

This article will specifically discuss the following questions:

1. Why is Tencent frequently increasing its share buybacks?

2. Where does the money come from for the billion-dollar buyback?3. With the gun raised, what's different this time?

I. One fact: Behind the increased buyback is the decline in glory

Looking back at the five years before and after the epidemic, in terms of income growth, a combination of factors such as regulation and competition led to an obvious "turning point in fate" in 2021. Tencent, which used to have over 20% compound growth and high rarity as a growth stock, has now been transformed into a slow-moving value stock that can only rely on cost reduction and efficiency improvement, as well as selling equity assets.

To protect the interests of shareholders, the management team also acted quickly. In the second half of 2021, Tencent, which rarely conducted buybacks, suddenly increased its buyback efforts, and the repurchase shares continued to expand thereafter.

At the same time, Tencent's dividend payout ratio (dividends/Non-IFRS net profit attributable to equity holders of the Company) has been steadily increasing. When combining buybacks and dividends to calculate the total return to shareholders, the proportion of net profit has increased from around 10% in 2017-2021 to nearly 50% in 2023 at lightning speed. According to the company's expectations for 2024, Dolphin Jun roughly calculated that the proportion of dividends + buybacks could further increase to 67%.

Objectively speaking, the intrinsic value of a company depends on its fundamentals. However, in terms of trading, starting from the middle of 2022, the continuous reduction of Tencent's major shareholders Naspers and Prosus, as well as the frozen trading sentiment in the Hong Kong stock market, have weakened the valuation support.

But aside from the pure trading impact, high-growth companies should still enjoy high valuations, and as growth expectations continue to be realized and surpassed, valuations will also rise. As a shareholder, if one cannot currently enjoy the benefits brought by the price difference, then the actual sharing of the company's profits will need to be realized.

II. Announcing another extravagant hundred billion buyback, where does the money come from?

Regarding Tencent's business model, the market has discussed it countless times, and everyone is basically familiar with it. It is well known that Tencent's business is profitable, but it is not without its challenges.

Tencent divides its business in its financial reports into four segments: Value-Added Services, Online Advertising, FinTech and Business Services, and Others. However, if further subdivided according to specific formats and business models, it can be divided into six segments: Online Games, Digital Content (businesses other than games in Value-Added Services), Online Advertising, FinTech, Business Services, and OthersAmong them, gaming, advertising, and financial technology are perennial cash cow businesses, while paid digital content (music, online literature, videos, QQ value-added services, etc.), and enterprise services centered around Tencent Cloud have been lingering in the loss-making stage for many years. The former, as several important pieces of the pan-entertainment ecosystem, has a synergistic value greater than its own commercialization; the latter is the core business of Tencent's To B strategy since 2018, but due to industry changes, the development direction also needs adjustment.

After two years of efforts in 2022-2023—focusing on core strengths, digital content has almost escaped losses, and Tencent Cloud's gross profit margin has also turned positive. One of the most direct changes this brings is that, despite stagnant revenue growth, the more important profit end for long-term shareholders—the scale expansion of the Group's Non-IFRS attributable net profit—has not fallen behind.

Since 2020, Tencent has been a golden egg that can earn billions annually, with a huge and stable user base in social traffic, which is the foundation supporting its continuous business expansion. As a platform-based company, the economies of scale after scaling naturally have higher economic benefits, and compared to other competitors in the same industry, most of Tencent's businesses have already taken the lead in the first step of traffic acquisition. Therefore, although the development of various businesses is uneven, from the perspective of the group/ecosystem itself, it is undeniable that Tencent is making "easy money".

Although the main business is like a money-making machine, before 2022, Tencent was not particularly generous to shareholders—annual dividends + rare repurchases, at least compared to the game leader NetEase, which is also in a highly profitable industry.

So let's take a look at where Tencent has been spending its money.

1. Past Spending: External Investments Account for Half

Generally speaking, after a company makes money, if it believes it is still in a growth phase, it will use most of the profits generated to ensure the normal operation of the business for expansion and reproduction + new business development, and a small portion will be returned to shareholders or simply kept in the company's accounts.

Although dividends to shareholders are generally allocated based on the net profit situation of the year, share repurchases need to be launched timely based on the company's financial reserves and market value fluctuations, as well as specific execution.

For giants with strong accumulated funds, in addition to the necessary expenses for their main business operations, they will actively seek external investment opportunities when funds are abundant, for synergies with their core business or simply for financial investments, acting as PE/VC to obtain investment returns. Tencent naturally falls into the latter category, and in the past few years, apart from the necessary expenditures for its main business operations, the largest outflow of funds has been used for external investmentsIn the previous article "The Other Half of Tencent's Value Given Away" on Longport App, Dolphin Jun focused on introducing Tencent's external investment situation in 2021 and the changing trends over the years. (The current situation will be updated in the next chapter).

Tencent's spending on investments is generally reflected in five main categories: (1) acquiring companies (business mergers), (2) investing in associates/joint ventures, (3) investing in financial assets measured at fair value with changes recognized in other comprehensive income, (4) investing in financial assets measured at fair value with changes recognized in profit or loss, and (5) investing in other financial instruments.

Among these five categories, items (1) to (4) represent investments in external companies/projects, while (5) is generally related to financial assets. While Tencent increases investments in these assets, it also disposes of/exits some asset projects. Dolphin Jun has also discussed how these investments affect current profits in "Further Discussion on Investments," and here is a summary chart without further elaboration.

From the perspective of actual cash flow, based on financial report data from 2016 to the first half of 2023 (the complete annual report for 2023 has not been disclosed yet), Tencent has a high willingness to invest, with the annual outflow of funds for external investments far exceeding the inflow of funds from disposals. However, starting from the second half of 2021, the difference between inflow and outflow has been narrowing.

As shown in the chart below, the narrowing difference reflects Tencent's accelerated disposal of investment assets, such as the well-known reduction of holdings in JD.com, Sea Limited, Meituan, etc., since 2022. It also indicates that Tencent is deliberately reducing new investments.

Reducing investments is not only due to the slowdown or even negative growth of the main business, but also mainly because the government has drawn a regulatory red line against "uncontrolled capital expansion."

Under this premise, Tencent has mainly used the additional "idle funds" compared to previous years to expand its share buyback program, while also reducing net borrowing increases (mostly USD loans for overseas investments, borrowing less and repaying more). Other cash uses, such as capital expenditures indirectly related to the main business and relatively stable changes in content procurement scale, have not expanded in sync with revenue growth.

2. Future Spending: Dividends and Buybacks will Account for Half

In terms of future cash flow usage, the cash outflows directly related to operating activities (mainly operating expenses) are expected to maintain a stable rate under the company's continued strict control policy. From a group perspective, the ongoing optimization and integration of internal operations can ensure that the scale of net cash flow from operating activities will not undergo significant changes, or will grow steadily with business expansion.

Cash flows generated from investment and financing activities outside of operating activities, including activities such as capital expenditures, content purchases, external investments, debt repayment, interest payments, and dividends and buybacks.

(1) Capital Expenditures, Content Purchases: Indirectly related to the main business activities, in the future, apart from potential incremental AI investments in capital expenditures, the overall growth should not fluctuate significantly. In fact, due to the company's reuse of resources and improved efficiency in resource utilization, there may even be a reduction in new investments. As shown in the chart above, since 2021, there has been a year-on-year decline in the scale of capital expenditures and media content purchases.

(2) Debt Repayment, Interest Payments: Tencent, due to the need for USD cash for overseas investments, generally borrows some USD from banks when interest rates are low for investment purposes. After 2022, as interest rates continued to rise to short-term highs, Tencent reduced short-term borrowings and commercial paper issuances. Despite maintaining the pace of debt repayment, the debt size has actually decreased in the past two years.

In the short term, overseas interest rates may still be at high levels, so the scale of short-term debt will not immediately return to previous highs. However, due to the needs of business development such as gaming overseas, maintaining a certain level of borrowing is necessary. Dolphin Jun expects that the overall borrowing and commercial paper size, including interest payments due in the current period, will maintain a dynamic balance after repaying maturing debts. In other words, with borrowing and repayment in balance, the contribution to net cash flow from operating activities is close to zero.

(3) Buybacks and Dividends: This future plan is self-explanatory and basically already clear. In the short term, the company disclosed in the fourth quarter financial report that it will repurchase over HKD 100 billion in shares in 2024, and a dividend of HKD 3.4 per share (totaling HKD 32 billion) was also distributed to shareholders this year. Therefore, the cash outlay for buybacks and dividends this year is at least double the level of 656 billion in 2023.

Based on the actual buyback scale in 2023 and the planned dividend distribution, it accounted for approximately 47% of Non-IFRS net profit attributable to equity holders. In the first half of last year, the company's management had a vague medium to long-term guidance (whether there have been any adjustments recently is unknown) - 80% of profits will be used to reward shareholders in the futureAccording to Dolphin's expectations for Tencent's performance in 2024, with the dividend payout ratio unchanged and an official announcement of a HKD 100 billion share repurchase, the estimated scale of dividend repurchase in 2024 is expected to reach 67% of Non-IFRS attributable net profit. This figure is much higher compared to 2023, but there is still room for improvement towards the management's long-term goal.

（4）External Investments: During the performance conference call in the fourth quarter of 2023, the management revealed that the future investment portfolio will continue to be "self-sufficient", with the significance to the group shifting from being a user of funds to a provider. In simple terms, the funds for Tencent's future external investments will come from the sale of existing investment assets, and efforts will be made to ensure that the funds inflow from investment returns (asset disposal, profit sharing) exceeds the funds outflow from new investments.

This clearly contrasts with the previous "investment > disposal" investment strategy. Dolphin believes that this not only reflects the long-term aftershocks of regulatory measures to "prevent disorderly capital expansion", but also signifies the end of an era - as the dividend from traffic flow diminishes, the development of mobile internet is nearing its end (further discussion to follow).

3. Funding Gap Determines Continuous Selling

By analyzing the different uses of funds mentioned above, it is evident that in the past two years, the main source of the funding gap for increasing repurchases and dividends comes from the reduction in investments, followed by strict control over various expenses directly or indirectly related to operating activities, resulting in increased profits from additional income.

As shown in the chart below, Dolphin attempted to deduce the fund utilization in 2024. To maintain a positive year-end net cash balance (cash + deposits - loans - notes) while sustaining normal operations, external investments, and the company's committed repurchase and dividend scale, at least 47.6 billion yuan of investment assets need to be disposed of. This is a high level similar to that of the past three years.

This also implies that the motivation to sell investment assets will not only be driven by regulations ("preventing disorderly capital expansion", equity asset ratio requirements for financial holding companies), but will also be propelled by the increased demand generated by the intensified repurchase and dividend policies starting this year.

With this conclusion, new questions naturally arise - with the need to sell existing assets to fund the new investment budget, who will Tencent abandon in its current investment pool? Who will it retain?3. The New Round of Puppet Game

By the end of 2023, Tencent's investment assets in the financial statements totaled 710 billion yuan. Considering the actual fair value, Dolphin calculated it to be close to 950 billion yuan, which is far from the peak value of 1.78 trillion yuan in 2020.

This is not only due to Tencent's net selling of assets, but also due to the overall downward valuation of the capital market. Of course, if we exclude the latter and compare based on the book value without considering the impact of market value fluctuations, the difference between the highest value in the first half of 2021, 845.1 billion yuan, and the 710 billion yuan in 4Q23 is mainly due to asset sales.

During the period from 2021 to 2023, Tencent's two largest divestment operations - JD.com and Meituan - did not involve cash flow changes as the divestment was in the form of physical shares distributed to Tencent shareholders. Most other asset disposals involved cash flow impact. Comparing the trend of changes in the book value of listed and unlisted equity assets, at least in terms of scale rather than the number of companies, Tencent is more likely to obtain income and funds through the disposal of listed equity. This is actually understandable, as listed equity mostly represents relatively mature companies in terms of business development, and trading exits after listing are also more convenient.

Therefore, as shareholders of these listed equity investments, it is important to pay attention to Tencent's actions. Especially for companies in which Tencent originally held a high stake, when Tencent needs to increase divestments to supplement funds for external investments, Tencent's divestments will have a significant impact on the short-term stock price fluctuations of these listed companies.

So, in the new round of the "Puppet Game," who will be selected in the first batch?

Although the need for divestment is urgent, past experience shows that Tencent will not engage in visibly loss-making transactions. Combining with the summary of several attributes with a higher likelihood of being divested as concluded by Dolphin in "Revisiting the 'Half-Life' Value Tencent Gave Away," we believe that listed companies with the following characteristics are more likely to be divested earlier:

(1) Need to focus bullets: Companies that do not align with Tencent's core business and favored sectors;

(2) Need to prevent capital from expanding disorderly: Companies in which Tencent holds a high stake (excluding those already acquired and consolidated) and have relatively mature development themselves;

(3) Need for a decrease in equity asset proportion: Companies in which Tencent holds high equity values(4) Currently, the valuation is relatively reasonable, or there are no companies that are significantly undervalued.

According to the requirements in (1), Dolphin Jun has summarized Tencent's investment activities after 2021, mainly reflecting the investment style as: making fewer moves, focusing on core business + innovation.

According to IT Orange data, with a reduced investment budget, Tencent's external investments have significantly decreased after 2021, while the proportion of investments around the core business has further increased. However, due to the small total number, the distribution of several core business-related tracks is similar.

It is worth mentioning that, although game approvals were suspended for most of the second half of 2021, it was still the field in which Tencent made the most investments during this period.

In addition, there are tracks representing innovative directions, such as AI and healthcare.

As a giant that has dominated for many years in this era, perhaps Tencent will expand its external investment scale again only when it achieves large-scale development in new eras (such as AI) and once again occupies a fundamental position in traffic. In other words, the importance of internal investment is significantly higher in periods like the early days of PC/mobile internet development in 2000 and 2010.

However, the pace of technological change in AI is too fast, and the industry's development speed far exceeds that of the early internet era. In the past year, while the infrastructure was still being iterated, many mature AI applications have already been launched. This is very different from the phased development pattern of "hardware - software infrastructure - applications" in past technological revolutions. The faster and more disruptive technological innovation has shortened the time gap between different development stages.

Therefore, Dolphin Jun also found that although Tencent's overall external investment scale has shrunk, investments in AI applications have rapidly increased over the past year.

The points in (2) and (3) above are both related to the market value of listed companies, so they can be combined to see: in the current listed equity pool, Pinduoduo's equity value is far ahead, followed by Universal Music, Kuaishou, as well as Sea, Snapchat, Beike, Futu. These are assets held by Tencent worth over 10 billion RMB, and Tencent's shareholding in these companies is not low, basically around 15%From the perspective of reducing equity assets and preventing the disorderly expansion of capital, excluding Universal Music and Snap, which will not be affected by the disorderly expansion of capital, the rest may face the possibility of reduction.

Considering the above two regulatory perspectives, Dolphin believes that the top 3 companies with the highest reduction risks are:

a. Pinduoduo: The company has matured, its valuation is not excessively undervalued, and there are currently some risks of weakening (competition from domestic Douyin in the e-commerce sector, Temu facing geopolitical issues). It is not Tencent's core business in the e-commerce sector, and Tencent's equity value is high. A small-scale reduction is more conducive to shrinking equity assets.

b. Kuaishou: The company has matured and started to stabilize profits. It is also a social platform company that directly competes with the emerging video platform. Although the current valuation is low, although it can imitate JD.com and Meituan in the Hong Kong stock market to clear out through physical dividends, the funds lack long-term faith in Kuaishou. Therefore, a significant reduction will have a greater impact and affect Tencent's exit returns. Both management teams are expected to discuss actions before taking action. Dolphin is more inclined to Tencent to continue selling in small amounts at the right time in the secondary market.

Kuaishou has started a continuous buyback mode this year, which may be to prevent or smooth out the slight reduction in Tencent's holdings (compared to 3Q21, Tencent's holdings decreased by 2pct in 4Q23).

c. Sea Limited: Although Tencent reduced its holdings in Sea Limited at the beginning of 2022, mainly reducing its voting rights in management and withdrawing Ren Yuxin's board seat, it still holds 18.4% of the shares. Sea's growth prospects are limited by various competitive factors, and the current valuation is not excessively undervalued. At the same time, in the subsequent gaming expansion into Southeast Asia, there may also be competition between Tencent and Sea.

However, considering that Sea Limited does not have a lot of diversified funds, and currently operates the international version of "Honor of Kings" ("Arena of Valor"), it is estimated that it will not choose to clear out in one go, but will gradually sell off.

Of course, other companies' shares may also be sold by Tencent, but the relative impact and immediate effect on Tencent are relatively smaller. Some high-quality assets are significantly undervalued, which will also weaken Tencent's selling intentions. However, it should be noted that once these high-quality companies rebound to a reasonable level, the risk of being sold off will increase. For example, after BOSS Zhipin's strong performance in 4Q23 led to a 20% surge in stock price, Tencent quickly sold off, although the reduction was minimal, it caused the company's stock price to undergo a half-month adjustment.

Therefore, Dolphin reminds that although some companies are indeed high-quality assets (such as Pinduoduo, Beike, BOSS Zhipin, etc., which will be considered for a separate article to update the logic and valuation), and some are currently in a period of strong performance. However, considering Tencent's strong intention to sell assets this year, it is not recommended to chase after short-term reasonable or slightly high valuations. On the contrary, after Tencent's selling pressure is released, the valuation that has been suppressed is the opportunity to buy lowEnd of Content

Dolphin Investment Research on Tencent

Financial Reports (Latest Two Quarters)

March 209th, 2024 Conference Call "Tencent: Games undergoing internal transformation, AI first effectively applied to advertising business (4Q23 conference call)"

March 21st, 2024 Financial Report Review "Tencent: Games in a daze, the stock king 'spending money' to restore honor"

November 16th, 2023 Conference Call "Turning towards 'high-quality growth' comprehensively (Tencent 3Q23 performance conference call summary)"

November 15th, 2023 Financial Report Review "Thrifty 'middle-aged' Tencent: Can't keep up with the pace, can only save, save, save"

Hot Topics & In-depth Analysis

December 22nd, 2023 "Here we go again, can Tencent and NetEase hold on?"

September 14th, 2023 "Learning from Ant Group comprehensively, digging deep into Tencent's financial second spring"

July 19th, 2023 "Tencent: Major shareholders selling off, can the stock king still have faith?"

January 17th, 2022 "Ant's butterfly effect: Will Meituan, Pinduoduo be left behind by Tencent?"

January 12th, 2022 "Revisiting the 'half-life' value given away by Tencent"

December 23rd, 2021 "Tencent bids farewell to JD.com: Happy breakup or painful parting?"On December 14, 2021, "Is it true that Tencent's stock price has reached a turning point along with regulatory changes?"

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