Naspers and Tencent – A Great Arbitrage Opportunity 3


It is common knowledge that big companies don’t have fast growth. This has become so ingrained in investor minds that many growth investors do not go anywhere near big blue chip companies. But with most theoretical concepts, there is an anomaly to the rule. The anomaly in this case is a $400 billion company growing at 40% a year. The company is Chinese and goes by the name of Tencent. Now I know what you are thinking when you hear where this company is based. But I urge you to read on and understand why I rate Tencent so highly and consider it one of the best companies in the world.

Tencent holdings is an online gaming and social media giant in China. It aims to own the screen time of the Chinese population. To put it simply, imagine all of the products of Facebook (including Whatsapp), Youtube, Netflix, Apple Music, Visa, Paypal, Nintendo and EA Sports rolled into one company. Now have I got your attention?

Tencent is broken down into 5 main businesses:

  1. Digital Advertising – WeChat has 938 million highly-engaged users.
  2. Mobile Payments – WeChat Pay is one of the largest mobile payment platforms in China
  3. Video Game Publishing – High margin, high Return On Invested Capital business that throws off significant free cash flow
  4. Media Subscriptions – Over 100 million people subscribe to Tencent’s news platforms, music, video, movies, and original content (think Apple Music, Youtube, and Netflix combined)
  5. Ecommerce – Tencent is a partner & minority owner of JD.com; WeChat is also a potential ecommerce hub.




Tencent’s Financials

Here is the a brief summary of the financials which shows the fast growth the company has experienced.

  • Revenue has grown from $4 billion in 2011 to $22 billion in 2016 for a compound annual growth rate of 39.8%.
  • Net profit has grown from $1.5 billion in 2011 to $6 billion in 2016 for a compound annual growth rate of 32%.
  • Operating margins stand at 34%
  • Return On Invested Capital is at 40%!
  • Free Cash Flow is expected to be at $8 billion for 2017. This cash flow generated from mobile advertising and game publishing fuels investments in areas such as music, content, the cloud and more. The high returns on invested capital shows cash is wisely spent and the company is expected to continue growing at this fast clip.

Why Is Tencent Growing So Quickly?

In order to understand why Tencent has high returns and is able to grow so quickly, you need to understand its economic moat – something special the business possesses which allows it generate above average returns for a sustainable period.

Tencent has a huge Network effect. The Economist summarises the network effect:

“E-commerce is another driver of the business model. The firm earns fees when customers shop at one of the more than 10m merchants (including some celebrities) that have official accounts on the app. Once users attach their bank cards to WeChat’s wallet, they typically go on shopping sprees involving far more transactions per month than, for instance, Americans make on plastic. Three years ago, very few people bought things using WeChat but now roughly a third of its users are making regular e-commerce purchases directly through the app. A virtuous circle is operating: as more merchants and brands set up official accounts, it becomes a buzzier and more appealing bazaar.”

To put it simply the super app that is WeChat is essentially the ‘operating system’ of China and touches everything in the country. It offer a highly valued user experience means that new and existing users are spending more and more time on the app. This in turn attracts businesses and advertisers to the platform as they want to sell its products to the users. This brings in even more users. This cycle goes on and on…

To date, WeChat has about 940 million users and this is growing at close to 23% a year! The app has 12 million official accounts ( think Facebook business pages). The average user spends 66 minutes a day on We Chat (more than Facebook and Instagram combines). Have a look at this from the Economist piece to find out why :

“Like most professionals on the mainland, her mother uses WeChat rather than e-mail to conduct much of her business. The app offers everything from free video calls and instant group chats to news updates and easy sharing of large multimedia files…

 

“Yu Hui’s mother also uses her smartphone camera to scan the WeChat QR (quick response) codes of people she meets far more often these days than she exchanges business cards. Yu Hui’s father uses the app to shop online, to pay for goods at physical stores, settle utility bills and split dinner tabs with friends, just with a few taps. He can easily book and pay for taxis, dumpling deliveries, theatre tickets, hospital appointments and foreign holidays, all without ever leaving the WeChat universe.”

We Chat has people locked into its ecosystem and this is a great strength as a business.

We Chat payments is also an interesting aspect as it is growing 200% year on year. It is used both online and offline. Its key strength is that it is cheap for merchants (businesses) to use and this has its own network effect in terms or bringing online more users. WeChat Pay has 40% market share in China with 600 million daily transactions.

Apart from having a huge networking effect, Tencent benefits from having a massive tailwind on its back and having a long runway aead of it. Firstly, Tencent is immune from foreign competition in China due to local regulation. Secondly, China has a rising middle class that is spending more time and money online and Tencent will be a big beneficiary of this.

Take online advertising for instance as a way of extrapolating the long runway. WeChat has ad revenue of $2.3 billion at present. A similar company – Facebook – had ad revenues of $2 billion in 2010 and only 6 years later this ballooned to $27 billion. We Chat has more users now than Facebook had in 2010. You can see where WeChats ad revenue is going!

The rising Chinese middle class will also benefit E-commerce. Tencent has a stake in another giant JD.com which did revenues of $38 billion last year. Furthermore, luxury brands such as Burberry have started selling products in We Chats platform. We Chat is fantastically positioned to extract a toll from the e-commerce industry.

One more advantage that Tencent has is that the company is still operated by its founder. Pony Ma (also called Ma Huateng) who started that company in 1998 owns just under 10% of Tencent and is focussed on creating long-term value by focusing on user experience. This is absolutely that way to go. Here is a great quote by Amazon founder Jeff Bezos “The balance of power is shifting toward consumers and away from companies. The right way to respond to this if you are a company is to put the vast majority of your energy, attention and dollars into building a great product or service and put a smaller amount into shouting about it, marketing it.”

Pony Ma knows all about changing and adapting and is always focussed on customer value. Here is an example. Tencent had a product called QQ, which was a desktop messaging platform that was also massively popular in China, and still has over 800 million users. Pony Ma recognized the shift to mobile, staffed two teams (one from QQ and one “outside” team) to solve
the issue. The QQ team came up with a product that was very similar to QQ desktop, but the outsider team invented WeChat. As seen from this article, WeChat is the heart and soul of the company.

Tencent Valuation

Tencent currently has a P/E ratio in the 40s. To most investors, this would seem excessively high. But the P/E ratio needs to be taken in context.

Consider what Charlie Munger (Warren Buffets business partner) said:

“If the business earns 6% on capital over 40 years and you hold it for that 40 years, you’re not going to make much different than a 6% return—even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you’ll end up with a fine result.”

Looking at the financials of Tencent, its Free Cash Flows, high ROIC figures and economic moats, the current price of Tencent may be considered cheap. I would be a buyer at current prices but I have found an even better way to buy Tencnet shares.



A cheap way to buy Tencent Shares – Naspers

Naspers is a South African holding company that operates in the internet and entertainment space. To keep it short, Naspers made a prescient investment in 2001 by buying a 33% stake in Tencent. Naspers paid $34 million for the stake in Tencent and today that stake is worth $132 billion! An over 65% IRR!

Here is where things gets interesting. So as mentioned, Naspers stake in Tencent is worth $132 billion. So how much is Naspers worth / its market cap? Only $97 billion. This means that buy buying Naspers shares, you are getting a 27% discount on Tencent shares. Crazy!

And that’s not all. Naspers in addition to holding a stake in Tencent, operates a profitable Pay TV business in Africa (Multi-choice /DSTV). Furthermore, Naspers has made investments in other successful start-ups like Delivery Hero, Ibibo, Allegro and Avito. See a full list of investments here and here. Buy buying into Naspers, you essentially get discounted Tencent shares and a whole lot of other businesses for free!

From my perspective, this huge discount shouldn’t exist. I am a little bit disappointed that I cannot hold Naspers in my ISA due to ISA regulations. But I will hopefully be looking into buying Naspers shares for my SIPP (Pension) and extract the value created by Tencent and Napsers others investments. The more sophisticated investors amongst you could put on a pair trade and go long Naspers and short Tencent – as long as the discount doesn’t widen you can look to profit this way. As always do your own research and due diligence.

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  • Maz

    Hi there
    I’m a longtime lurker on your blog and enjoy your posts! Just wondering what your thoughts are on how the 27% discount translates to a better deal for a private investor? I’m not sure how Naspers would monetise their Tencent holding, when Tencent’s dividend is less than 1% at the moment (typical of most large cap tech companies), unless they dispose of tranches of their holding? Also, would be great to know your thoughts on a situation where Naspers disposes of its stake but without returning full value of that disposal to shareholders, or where Nasper’s share price doesn’t rise commensurate with Tencent. As both Naspers and Tencent are currently trading at $45 and $41 respectively, I’m just wondering what makes it more attractive to own Naspers than a direct stake in Tencent (which can be held in both an ISA and a SIPP if you have a Hargreaves Lansdown account).
    Thanks for listening!

    • http://moneygrower.co.uk moneygroweruk

      Hi Maz,

      Welcome to the site. That is a really good question. This is exactly what makes investing interesting and intellectually stimulating. There is no simple answer and you need to make educated judgements based on the facts at hand.

      You do make some really good points. At present, Naspers 33% stake is strategic so it could give them first refusal or make them partners on certain Tencent project. Novartis uses its strategic stake in Roche to its advantage and so does BP with Rosneft. So keeping a strategic stake in a company has its on merits. Your question revolves around monetising the stake. At present, there is no plan to do so. The Naspers CEO as recently as June stated that they have no intention off spinning-off the stake in Tencent. He further went on to say ““From the moment Tencent was listed on Hong Kong stock exchange, some had been asking us to do that. You can imagine how unhappy shareholders would be if I had done that 10 years ago.” So if you are investing based on the exit of the stake in the near future, I would suggest you look elsewhere. But if they were to dispose, they would probably do it in tranches or in one lot at a discount as many other companies have done.

      Your next question as I read it correctly is what happens in the situation that Naspers sells the entire holding and does not return the money to shareholders. This is exactly the fear many other investors have! The reason for the discount is because investors think Naspers got lucky with its ‘once in a lifetime’ investment in Tencent. Investors fear that Naspers management cannot redeploy capital in the same way as it did when it invested in Tencent – and looking at the financials there is some suggestion of this. (Additionally, the discount is also created due to macroeconomic risks such as the political situation in South Africa).

      I have no doubt that investors over the long-term will do well no matter whether they invest in Naspers or Tencent. From my perspective, Naspers is more attractive as I would expect the significant discount to close over time and Naspers shares to have far greater upside than that of Tencents as a result of this. With Napsers shares, you essentially get all the Tencent upside and you get the bonus of having stakes in all the other companies Napsers own. Obviously, the discount can widen in the short-term and that is why I have taken a long term view. If you want to hedge your position to limit downside, it would be worth looking into a pair trade involving going long Napsers and Short Tencent – this would be a simple play on the discount.

      Hope this helps.

      • Maz

        Thanks for a thoughtful and comprehensive reply – I really appreciate it! I take a long-term view of my investments and am long on Tencent, so I was very glad to see a thoughtful blog post about the company’s merits. Your post about Tencent and Naspers made me think of another popular strategic play for a stake in large cap Chinese tech firms – Japan’s SoftBank has one of the largest stakes in Alibaba (even after their 2016 partial disposal) and trades at $40 to BABA’s $170. Looking forward to reading more of your posts!