The Great Collapse Won't Be Their End. Tencent Is Poised To Rise Again.

(Spencer Platt/Getty Images News)

- Summary -

• The TME share price overreacted to news of sanctions against it. After what happened to DIDI, Chinese crackdown worst-case scenarios were already priced in.

• The delisting narrative that instigated a lower price a few weeks ago has calmed down.

• TME is oversold in the midst of not yet recovering from a massive discount in share price which stems from the collapse of Archegos Capital Management in March 2021. 

• The company is driving shareholder value with an aggressive $1 Billion Stock Re-Purchase Program. 

• 20% stake in Universal Music Group has big potential for payoff.

Intro

In our view, Tencent Music Entertainment (NYSE:TME) remains one of the most undervalued Chinese listed companies on the New York Stock Exchange. In this article, we will detail why we think this stock is currently trading under its fair value and how upcoming developments, particularly the 20% stake in Universal Music Group, has the potential to support considerable revenue growth in the next few years.

With low debt, huge cash reserves, and a respectably increasing EPS, it is clear that investor expectations have been impacted by the constant threat and brinkmanship of further regulatory action by the Chinese government. We believe the worst of that is mostly behind us and that it won't have a major effect on the profitability of this company. It is our view that it has overreacted to news that doesn't change the fundamental value of the stock. If our thesis plays out as correct, there will be a significant upside to the current share price. 

Background

TME has historically been seen as a diamond in the Chinese IPO rough. Easily quantifiable growth and rising profit margins attracted many investors, such as the famed and over-leveraged family office Archegos. The currently depressed share price of TME can't be adequately explained without mentioning them. When Archegos Capital Management faced margin calls in late March of this year, what began was the descent of the TME share price and it is yet to recover. The price has spiraled downwards from $32.25 on March 23rd, 2021, to the $18 range a few days later. Regulatory measures by the Chinese government have further caused selling pressure that has resulted in today's price in the $10 range.

Investment Thesis

In the following chart, we can see how TME had seemed to begin a consolidation phase and once again trade within the range of the broader technology market (NYSEArca: XLK) in the immediate aftermath of the Archegos incident. This has widely diverged since, and the drop in mid-July coincides with a media fear-mongering onslaught regarding possible sanctions that have since came to pass. In our view, the potential impact of those sanctions was priced into the stock before the recent skids in value.  

We believe it is a matter of time before this corrects itself and TME begins to outperform the broader market segment. There is a noticeable difference between the company's fundamentals and the current valuation the market gives, which sets the company up for outsized returns in the coming months or years.

Source: TradingView.com

1. They don't rely on one source of income

This is a key aspect of Tencent's attractiveness as an asset in comparison with other music-streaming services. The bulk of Tencent's actual profit margin is earned on “social entertainment services” derived from their live streaming application and advertising sales across platforms. Secondary revenue consists of “music subscription fees”. This large and growing installed base of music-subscription users has already reached a critical mass. The true revenue potential of Tencent Music is only beginning to be realized and we expect major growth stemming from the further monetization of paying music subscribers.

2. TME has major upcoming growth catalysts

Tencent has a history of forging open and mutually beneficial strategic relationships like they have done with Spotify (NYSE:SPOT).

Increasing the stake in UMG, who IPO in September, is seen to signal further co-operation plans between the two firms. UMG owns many internationally recognized singers’ music rights: The Beatles, Queen, Taylor Swift, and Billie Eilish, as just a few examples. Tencent and its co-investors would “enable UMG to further develop its activities in Asia” said a spokesperson for Vivendi, the parent company of UMG.

TME's strategy appears to be centered on focusing on expanding the growth of their music-subscription business, making strategic partnerships and constant improvements to their platform while effectively monetizing their large installed base of users. 

3. Strong Balance Sheet with solid profit

They have met earnings and turned a profit year after year. Recent headlines have not changed the fundamental strength of the stock. As of March 21, 2021, the installed base of paying music users reached over 60 million which can drive into high-margin revenue streams going forward. It is also likely true that the music-subscription revenue will surpass the social entertainment services revenue by the end of 2021 in both profit margin and contribution to earnings. The key factor in the coming years will be whether or not TME can continue to develop the revenue base of these paid subscribers, which we believe they are well-positioned to do.

4. Show me the money!

Another key factor in our bullish stance is the fact that Tencent announced an aggressive plan to re-purchase $1billion worth of shares in March 2021, that will play out over the 12 month period ending in March 2022, of which they have insofar bought back around $200 million worth of at last count. This leaves over $800 million worth of TME stock that will be bought back from the market by TME, between now and March 2022. This buyback, at the currently depressed prices, will help bolster up an emerging level of support. What we like to see is that TME and its board are keen to take proper advantage of these underpriced shares.

5. But what about the burrrrrrrs?

The standard bearish case for TME outside of regional regulatory concerns focuses on overall user saturation and perceived low paid-user growth rates. They hyper-focus on MAU falling in Q2 for the first time as evidence that TME has reached its peak, yet this take is misleading because it fails to account for the fact that in Q1, TME nearly quadrupled their long-form audio MAU penetration to 20% in the first quarter, compared to 5.5% in the previous year. On a year-over-year basis, the growth metrics of this company should justify a positive impact on the share price.The most common objection I have heard from those skeptical of the validity of the argument that TME is grossly undervalued at the current price levels is “It looks alright, but isn't Spotify (NYSE:SPOT) a better buy, in that space?” 

For me, the answer is a clear NO and the chart I've included below tells the story. Tencent is a profitable company. It made about as much as Spotify lost, last year. Its valuation doesn't rely on future potential tied to lofty expectations based on growth metrics. It is dominating its market and has established replicable profitability, which is more than can be said for most Chinese tech listings and rather impressive compared to its North American counterparts

Source: marketbeat.com

Conclusion

We view Tencent as a compelling opportunity to generate returns in excess of 100% within 12 months, in line with Wall Street analyst expectations. The company has large cash reserves, low debt, and a depressed shared price over an extended period of time. The state of the current stock price is due to external factors that are irrelevant to the underlying robust profitability of the company. This all provides major downside protection. The company is actively driving shareholder value through buybacks, strategic partnerships, and M&A. The catalyst for this upside potential could be the Universal IPO in September, although another earnings beat could also give a nudge. It is our view that, as the delisting concerns evaporate, more institutional money will drive demand ahead of any upcoming developments and we can expect to see the share price begin to appreciate as this happens.

We reason that the strong fundamentals and growth potential will drive this stock price back upward. The recent sustained dip instigated by Chinese government sanctions is more than accounted for in the discounted price. When these lingering fears subside, the strong fundamentals of this company gain back the attention of the market and the share price with it.

Risk Factors 

China can be a challenging business environment and there is no guarantee that Tencent will be successful in navigating those challenges. While most of the company's applications have reached, in our view, a critical mass, there is no guarantee they will remain relevant with consumers in the future. There is a risk that the SEC decides to target TME with a new law, but we see it as highly unlikely. It is possible that management makes mistakes that negatively affect the share price and there is no guarantee that future joint ventures will have meaningful commercial success or that the current profitability will be sustainable. We make assumptions that may not hold over time. As with any other equity investment, the company is subject to various market, regulatory, and foreign exchange risks.


Disclosure: 

I am/we are long TME. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article. I/we have no position in any other stock mentioned in this article

Update Feb 2023 -  We closed out this trade for a considerable loss in Feb 2022 and are not still recommending a buy at this time.

Additional Disclosure:

The views expressed in this article are the opinions of the author as of the date of publication and do not constitute a recommendation to buy or sell any security. Opinions are subject to change without notice and the author is under no obligation to update their views on this forum. This is not investment advice and is being provided for informational purposes only. You should not rely solely on the information or opinions provided in our content, rather use them as starting points for your own due diligence and draw your own conclusions based on your own research. The author cannot guarantee the veracity or completeness of any information provided in this forum and will not be responsible for inadvertent errors or omissions. Please do your own due diligence and invest responsibly as you alone are responsible for your own investment decisions. Investments carry risk, are not guaranteed, and can lose value.