Why the Worst May Be Over for Tencent Stock

Tencent stock - Why the Worst May Be Over for Tencent Stock

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The U.S. stock-market selloff started in October. But Chinese stocks have been tumbling all year long, due to slowing economic growth and concerns about rising trade tensions. At the top of the list of losers is once high-flying-Chinese-internet giant Tencent (OTCMKTS:TCEHY) stock.

The company, which is often dubbed the Facebook (NASDAQ:FB) of China, but is actually so much more, has seen its growth rates tumble amid a slowing China economy, while its margins have continued on their multi-year downtrend, pressuring the company’s profit growth and the valuation of Tencent stock.

Consequently, Tencent has dropped 35% from its early-2018 highs.

For a while, Tencent stock was a falling knife. Tencent’s revenue growth was slowing, and its margins were declining. Also weighing on TCEHY were near-term headwinds from escalating trade tensions and slowing Chinese economic expansion. The U.S. dollar was only strengthening, adding further downward pressure on Tencent.

But this falling knife may have just bottomed.

The company’s near-term fundamentals are improving. Namely, the strength of the dollar is dissipating, trade-war tensions are calming, and the video-game freeze in China is finally over. Also, technicals indicate that Tencent stock bottomed in late October and early November. All told, the outlook of the company’s long-term fundamentals is now more favorable than it has been at any other point in 2018.

As a result, TCEHY may be in the process of transforming from a falling knife into a long-term winner.

The Near-Term Fundamentals of Tencent Stock Are Improving

There have been three headwinds which have weighed on TCEHY in 2018. All of those headwinds are showing signs of easing or even reversing course.

First, robust U.S. dollar strength has diluted the value of all Chinese equities, including Tencent stock. The dollar surged in mid-2018. But after the dollar tested its five-year highs against the Chinese yuan in November, the strength of the dollar has tapered off. That’s a positive development for Tencent stock.

Second, rising trade-war tensions have caused the Chinese economy to cool, and that has, in turn, weighed on Tencent’s revenue growth. But progress is being made towards resolving the trade war; most notably, China has lowered its auto tariffs. Although the trade dispute is still a long way from being resolved, and China’s economy is still suffering from the conflict, every little step towards a resolution is a positive development for beaten-up Tencent.

Third, China postponed approving new video games in March due to Beijing’s growing concerns about violence in the games. Video games have historically accounted for 30%-40% of Tencent’s revenues, so the freeze was a big deal for Tencent stock. Indeed, while all of Tencent’s other operating segments grew by roughly 20% last quarter, the revenue of Tencent’s video-game business dropped 4%.

Now, though, the freeze is over. China is finally giving the green light to new video games for the first time since March. That’s a positive development for TCEHY, since the growth of its video-game business could be reinvigorated, causing its overall revenue growth to accelerate.

The Technicals of TCEHY Look Good

Improvements in the company’s near-term fundamentals have coincided with a bullish, double-bottom pattern in the chart of Tencent.

In late October, Tencent stock bounced off a $32-$33 bottom. TCEHY then re-tested the bottom and held it again in mid-November. Both times, the bounces off of $32-$33 were quite large. In late October, TCEHY jumped from $32 to $38 in just a few days. In mid-November, it surged from $33 to $38 in just a few days, and then broke out to new multi-month highs of $40-plus in early December.

This is a classic, double-bottom pattern with a stronger, sustained second breakout. Thus, the chart is saying that Tencent stock has bottomed, and that the falling knife is now reversing course and starting a medium-to-long-term uptrend.

Long-Term Fundamentals Could Improve

Tencent’s big problem is that its revenue growth is decelerating and its margins are falling. But if those two trends reverse  then TCEHY could head a lot higher over the next few years.

The company’s revenue growth had been decelerating due to the slowing Chinese economy and the video- game freeze. But if trade-war tensions ease in 2019, then Chinese economic activity should pick back up. Also, the video-game freeze is over, so Tencent’s video-game business should come back to life in 2019. All together, it looks fairly likely that the company’s top-line growth will average 20% per year over the next five years.

Tencent’s margins have been falling for several years due to its development of new businesses. Eventually, the company will stop adding new businesses, and those it has launched will grow and become profitable. As a result, over time, the company’s margins should increase. Realistically, Tencent’s margins should rise to 30% within five years.

Given all of those assumptions, TCEHY has the ability to produce about $33.5 billion of net profits in five years. Applying a forward multiple of 20, which is average for internet stocks, yields a four-year valuation target of $670 billion for Tencent stock. That represents upside of 75%-plus from today’s $380 billion market cap.

The Bottom Line on TCEHY Stock

Fundamentals, charts, and sentiment all indicate that Tencent has bottomed. How much higher this stock goes depends on when and at which point the company’s margins stabilize. But if its margins simply head marginally higher from here, Tencent can rise tremendously from current levels over the long-term.

As of this writing, Luke Lango was long TCEHY and FB. 


Article printed from InvestorPlace Media, https://investorplace.com/2018/12/why-the-worst-may-be-over-for-tencent-stock/.

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