In an era of easy money, algorithmic trading, and profitless tech giants, one can easily question whether classic fundamentals still apply.  Given all the oddities and changes of our times, the answer is a resounding, if surprising, yes.  

More striking yet, where better to test fundamental analysis than in the tech sector, the land of the sky-high multiples?  The modern investor does not necessarily need to find elevated multiples anathema, as long as they are backed by high quality earnings and cash flow growth.  An examination of the Chinese technology firm Tencent illustrates that fundamentals can, even today, find value in the market’s loftiest sector. It all comes down to determining which companies can best translate technological innovation into cold, hard cash. 

The Posterchild of Tech Value: Tencent (TCEHY)

Tencent Holdings represents one of the largest technology conglomerates yet to penetrate the consciousness of the American investor.  Many I speak with have never heard of the Shenzhen-based firm, much less that it is currently the world’s 8th largest  company by market capitalization, only a handful of billions behind fellow Chinese compatriot Alibaba.  With a market cap of $438.1 billion and $21.9 billion in revenue in its most recent fiscal year (FY16), Tencent has demonstrated remarkable growth sustained from its myriad lines of business. 

Specifically, this Chinese internet firm achieved revenue growth over the last three years at a 36.0% CAGR, with a 47.8% increase in FY16 alone.  This ability to realize growth has fueled a 219.5% appreciation of share price since 12/31/13, outpacing the gains Hang Seng Index nearly tenfold, by a factor of 9.95, over a commensurate time period.  Impressively, all this growth is attained while yielding a healthy net profit margin of 27%, and this ability to scale rapidly while delivering substantial profits is the source of this company’s value.

Beyond financial performance, Tencent Holding’s strength is derived from its intelligent monetization of internet technologies.  Foremost, the company’s flagship endeavor is WeChat, which enjoys de facto monopoly status in the Chinese social media and messaging market.  Tencent followed up the success of WeChat by adding a payments application, named Weixin Pay, and currently divides the $5.5 trillion Chinese mobile payments market in duopolistic fashion with Alibaba, garnering a 37% market share.

Tencent’s Long-Term Strength

These ventures speak to Tencent’s understanding of how to extract value from user interaction with smartphones, and revenues from mobile and online gaming are a critical element to this success.  With gaming an over $100 billion market globally, Tencent has positioned itself as the leading publisher of mobile games, generating $1.55 billion in revenue in Q1 2017.

The company compounds this organic success with a series of strategic acquisitions, in particular its purchase of mobile game publisher Supercell with its incredibly popular Clash of Clans franchise.  Notable is that this subsidiary is the world’s second largest mobile publisher generating $2.3 billion in revenue in 2016.  With near gender parity in users of games, and more gamers over the age of 50 than 18 and under, Tencent is capitalizing upon a secular uptrend. 

Most significant about Tencent’s corporate strategy is the internal synergies operating between its business ventures.  As the lines between messaging, gaming, social media and payments blur, driven by the popularity of micro-purchases, Tencent uses each line of business not only for customer acquisition, but also to cross-sell to other revenue streams.  This business model operates as self-reinforcing cycle, where user growth leads to increased per-user revenue through cross-selling, which in turn renders further users even more valuable allowing for ever more aggressive acquisition.

It is akin to a Portuguese man o’ war, with separate organisms, tentacles included, working in concert for mutual benefit.  Operating with this formula, Tencent gains from ample growth opportunities, not only from the continued penetration of mobile technology into the Chinese economy, but also from international expansion as well.  It may not be long before you join the over 963 million WeChat users, with the platform opening to western advertisers just last month.

The Long and Short of It

With Tencent’s continued potential for profit growth both domestically and internationally, the case for finding value in technology can be readily made.  As with any other sector, fundamental analysis can find in the technology field companies that can extract economic value, and those that squander it.  This style of analysis reveals that value lies in the creation of robust and steadily increasing cash flows; much of the rest of the hype is rather extraneous.

Tencent generates striking value from monetizing smartphone use.  The company has identified, dollar for dollar, the most valuable revenue stream stemming from the internet revolution, not manufacturing the phones or selling internet service, but by providing enticing user applications to consumers.

Indeed, the more investing changes, the more it stays the same.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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