Introduction: How to quantify and understand the rising importance of shareholder returns. Since 2022, Tencent's overall revenue has begun to slow, and cost reduction and efficiency gains and shareholder returns have begun to become new concerns. However, we have also observed that Tencent's cash dividend ratio has continued to rise in the past two years, and record repurchase amounts, and shareholder returns have begun to become clear. And after focusing on shareholder returns, how much financial improvement will Tencent actually unleash? Focusing on this change, this article mainly explores three questions: 1) How to quantify the impact of shareholder returns? 2) Where does the motivation for continued shareholder returns come from? How much potential for improvement? 3) Under the new paradigm, how to reference Tencent's valuation?
How to quantify shareholder returns and the new paradigm of growth:
1 Dividends and buybacks may result in neutral/optimistic 3.2/4.1% after-tax shareholder returns for 24 years. Tencent's current shareholder returns are divided into two parts: cash dividends and repurchases. The cash dividend ratio has increased significantly in the past two years (10.7% in '21/18.5% in '23). In terms of repurchases, large repurchases began after the majority shareholders announced long-term holdings reduction plans in '22, and the amount was further increased after a draft solicitation of comments in December '23. In the 23 annual report, the company announced that it would double the repurchase amount to more than HK$100 billion in 24; as of 24H1, the company had already repurchased the amount for more than 23 years. Furthermore, after deducting the dilution effects of dividend tax and equity incentives, we expect shareholder returns of 3.2%/4.1% in 24 years based on the 24H1 closing price under neutral and optimistic circumstances.
2. With a reduction in share capital, EPS growth in 24 is expected to lead profit by 2.4 pct-3.3 pct. Another impact of large repurchases is that EPS is expected to continue to grow faster than profits. In addition, at this stage, Tencent's high-growth new businesses (mini-program in-game purchases, e-commerce technical service fees, video account advertising, etc.) all have high gross profit margins, as well as their own operating leverage effects and profit release for invested companies. The growth model of EPS growth rate > net profit growth rate > gross profit growth rate > revenue growth rate is expected to become a new paradigm. We expect EPS growth in 24 to lead the profit growth rate by 2.4 pct-3.3 pct.
Where does the motivation for shareholders to return come from? It is expected that it will continue to improve. Another possible question for investors is whether the cash flow can meet these high shareholder returns, and is there room for improvement in the future? This can actually be broken down into two questions: 1) whether free cash flow from equity can expand with profits; 2) how free cash flow from equity can be distributed in expanding reproduction and shareholder returns.
1. The competitive environment is stable, the position in the industrial chain is high, and long-term stability of cash flow is expected to be better than profit in the statement. The competitive environment faced by Tencent is in a better category among various Internet giants — the high-intensity crowding of short videos has come to an end, and games and payments (number of transactions) have steadily ranked first in the industry. Other than AI, there is currently no new direction to invest in huge cash flow. Coupled with the strong upstream and downstream bargaining power, business selection ability, and high C-side share of the Internet platform itself, it is expected that long-term stability of free equity cash flow will be better than reported profits.
2. In terms of distribution, foreign investment has declined sharply, shareholder returns have increased dramatically, and there is still room for growth in absolute amounts. Twenty-two years ago, Tencent usually used a large proportion of free equity cash flow for foreign investment. We dismantled foreign investment since '18, and found that starting in '22, the cash flow used for foreign investment began to drop drastically, and even contributed positive cash flow in '23. In contrast, cash expenses from shareholder returns began to expand in '22 and became the main export of free equity cash flow, but they still accounted for less than 50% in '23. We expect to drop to 62%/78% in the above neutral/optimistic scenario in '24. Looking ahead, we expect the absolute amount of shareholders' return expenses to continue to increase, and the share is expected to remain at a high level.
Profit forecast: We expect the company to achieve revenue of 670.6/732.9/792.9 billion yuan, YOY +10%/9%/8%; NON-IFRS net profit of 210.1/234.9/258.9 billion yuan, YOY +33%/12%/11%, corresponding to the current market value PE16x/14x/13x. ; Achieve EPS (basic) of 22.91/26.26/29.79 yuan under non-IFRS caliber, YOY +37%/15%/13% (considering changes in share capital due to repurchases and equity incentives).
Valuation Review and Discussion: How to Value Tencent under the New Paradigm?
1 Looking back at history: Industry trends have brought about two cyclical fluctuations in the valuation system. Since its launch, Tencent's valuation system has experienced two cycles of fluctuations in the PC Internet and mobile Internet industry trends.
At this point, the mobile internet era is maturing. Coupled with changes in the external environment, revenue and profit growth rates have actually declined during the 21-22 period. Since then, with the release of the results of cost reduction and efficiency, the profit growth rate has returned to a relatively high level, but since the revenue growth rate is still slow and there is no second growth curve, the market still uses weak growth. The current PEG level is 0.5, which is similar to the situation in 08—11, but the difference is that shareholder returns have increased markedly.
2 Valuation discussion: Stable pattern+shareholder returns+assets with a certain growth potential, combined with the attributes of technological growth capable of starting the next valuation cycle. We believe that subsequent valuations are expected to determine growth by simply referring to revenue growth, and switching to a combination of EPS growth rates to reflect value more by stabilizing the pattern+shareholder returns+assets with a certain growth potential. Furthermore, we believe that Tencent's technological growth attributes should still not be ignored. Just as it moved from the PC era to the mobile phone era back then, if the next round of technological innovation comes, it is expected that Tencent will once again have the potential to show strong growth and drive the valuation system to start a new cycle.
3 Target price and investment advice: Give the company a target valuation level of EPS 18-20xPE under the 24-year non-IFRS caliber, corresponding to the 2024 target price of HK$453.08-503.42 (considering changes in share capital due to repurchases and equity incentives). The margin of safety consists of shareholder returns. Combined with the current yield on 10-year treasury bonds between China and the US, we believe 4% is expected to be the reference base for long-term capital, which is basically the current market capitalization level. Moreover, even at a time when technological innovation is still taking time to materialize, we believe that Tencent's comparative advantage has begun to be reflected. The Tencent outlook, which has a stable competitive pattern, is risk-resistant, and still has growth+shareholder returns, can still see 65% of the stock price space in 3 years (considering changes in share capital due to repurchases and equity incentives). Maintain a “Recommended” rating. (The exchange rate is 0.91 RMB/HKD)
Risk warning: Changes in policies and competition patterns; technological iterations change business models; macroeconomic fluctuations; game business flow delays longer than expected.