Kate Lin: Welcome to the Morningstar Asia Outlook for 2023. I'm Kate Lin, a data journalist, based in Hong Kong.
For a large part of 2022, Chinese game developers suffered as new permits from government officials were passed. This ended only recently. This, coupled with the positive news of relaxation of COVID restrictions, meant Tencent Holdings (00700) spiked as much as 60% from its low. Does this indicate a bright start to the new year for investors in Chinese entertainment platforms? We're asking Ivan Su, senior equity analyst at Morningstar.
Hi, Ivan.
Ivan Su: Hey, Kate.
Lin: Macroeconomic weakness is the major headwind pressuring Tencent's advertising revenue. What is your expectation for 2023?
Su: Yeah. So, last quarter, in 3Q 2022, we said that the worst is over for Tencent, and a recovery is just around the corner. And what we're seeing recently is with China's reopening measures such as allowing home quarantine and also the abolishment of digital tracking app, these measures really reaffirm our positive view that Tencent's advertising business is on track for a strong turnaround. For 2023, we are expecting Tencent to grow its advertising revenue by 25% year-over-year compared to the roughly 10% decline that it's recorded for 2022.
So, there are three main factors that's driving our above-consensus forecast for 2023. Number one is we expect an improvement in economic situation to increase overall advertising spending. So, the overall market will get bigger. Number two – we expect Tencent to gain market share in the advertising space, driven by more advertisers spending on brand ad as opposed to performance ad.
So, just some background context. Most of Tencent's advertisements are in brand ads where the ad formats are focused on establishing consumer awareness as opposed to the performance ad where the main goal is to generate leads and sales. And since early 2022, we've seen advertisers pivoting to performance ads because of the overall deterioration in the Chinese economy. But with reopening on track, we think advertisers will shift back to brand ad and that's going to benefit Tencent and lift their overall market share in the advertising space. So, that's number two factor.
The last factor that we think will drive our above-consensus forecast has to do with new advertising products such as video accounts that are launched by Tencent very recently. We see these new advertising products as to have a lot of potential in generating incremental advertising opportunities as they increase overall user time spent on Tencent's platforms. So, those three reasons combined drive our above consensus advertising forecast going forward.
Lin: So, are these why you like this stock even through its low? What else do you like about this company?
Su: Yeah, there are plenty of reasons why we like Tencent. And I think the biggest reason really has to do with its 1.3 billion user network that Tencent has. WeChat is the most widely used apps in China and the value of its network is amplified every day with greater user engagement and repeat users. And we think Tencent's established strong network effect already created very high barrier to entry for competitors. The data that Tencent has amassed about its users continue to increase their switching costs and decrease their transaction costs. So, that positions Tencent to be a very strong wide moat company that will continue to deliver incremental revenue and profit going forward.
And sticking down a bit more on the revenue side, we think there is also ample room for Tencent to grow and to monetize its platform, whether it's through video accounts which we just mentioned, or enterprise software such as Tencent Meeting or even other new revenue streams that the company will obtain through continued technological advancements.
Lastly, but not least, valuation for Tencent is currently still at historical lows, and we believe Tencent's shares currently offer very compelling long-term investment opportunities to investors out there.
Lin: Right. But Tencent's ad sales can be volatile somehow. Should investors focusing on games look at pure-play NetEase Inc (09999) or CMGE Technology (00302)?
Su: Yeah. So, with the Chinese government resuming its game license approval, we also recommend investors to start taking a look at online gaming stocks such as the ones that you mentioned.
NetEase is our top pick in the gaming space though because we like how the company has industry-leading game development capabilities. So, that translates to better games and more users playing their games. On top of that, NetEase is also expanding outside of China through acquisitions of a lot of game studios. So, we expect the company's overseas investments to drive revenue growth outside of China over the longer run. So, that provides also quite a bit of run room for NetEase to grow too.
Lin: So, a few months ago, you also initiated a coverage of Tencent's music arm that is Tencent Music Entertainment (TME) and its rival Cloud Music (09899). How are they doing and which one of the two is your pick now?
Su: Yeah, that's right. We initiated coverage recently, and we think Tencent Music is best positioned to generate the most earnings and revenue in the online music space. And the reason that we think it will be able to do it is because it also has a very strong user network, and it also has a proven track record of profitability. Tencent Music is the largest provider of music streaming services in China. The company currently has close to 600 million monthly active users, but only 80 million of them are paying for subscriptions at the moment. So, this translates to a subscriber to user ratio of just about 15%, which is significantly lower than the 45% that we are used to seeing at firms like Spotify Technology (SPOT). That said, as Chinese consumers continue to get into the habit of paying for music, we expect more people will become subscribers of Tencent Music. And so, that translates to also double-digit earnings revenue growth going forward. Despite the recent rally in Tencent Music's share price, we still find its shares undervalued at the moment, trading at about 15% discount to our $9 fair value estimate.
Lin: Thank you so much, Ivan. Stay tuned for more on the Outlook series.
.jpg "Kate Lin")
