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  • KPB & Co Research

Fiscal year 2018 turned out to be a tough year for Chinese tech giant TenCent Holdings Limited (OTC: TCHEY). The American depositary receipt (ADR) got hit hard declining by approximately 35% percent from its January-2018 highs of US$59.2 per ADR. The decline in the ADRs came on the heels of a 19% percent decline in the mobile-game business, and reductions in interest income. In the later part of the year the stock regained some of the lost value on positive news and decent financial results, but heightened trade tensions are likely to weigh on the stock for a few months.

The Chinese government's heightened scrutiny of mobile games has led to a sharp slowdown in the number of games approved for distribution throughout the gaming industry in China. There have been concerns by Chinese authorities that the proliferation of these mobiles games has led to addiction, and excessive teenage spending. Consequently, Chinese gaming companies have had to revamp how games are distributed across their platforms. Some of the actions TenCent took include controls to how much young people can spend on its games, and limits to the play time for those children under 12. Regulators also halted approvals for in-game purchases, an avenue that TenCent generates significant revenues from. Revenues and gross margins also got hit from changes in the financial regulatory landscape. Its online payment business saw decreased interest income due to the People's Bank of China's decision to increase the required cash need to maintain deposits from 52% to 100%.

Fortunately for the company, Chinese regulators appear to have lifted the freeze as they have issued licenses for 80 games in late 2018. Those licences were for games made by micro sized domestic developers. Industry experts are largely positive about a nationwide lifting of the freeze, and are expecting a ramp up in the number of titles approved over the next few months. There is a backlog of around 5,000 games in need of approval, and the consensus is that it will take about 6-8 months to clear. After this backlog is cleared many expect that the heighten censorship to reduce the speed at which licences are granted relative to historical norms.

Tencent is also in a position to make significant investment in developing new titles not only due to its strong Free cash flows, but also due to the cash coming in from the initial public offering of its music arm - TenCent Music. TenCent raised close US$1.1Bn from the Initial public offering which the valued the entire music arm of the business at roughly US$21Bn.

In spite of the of all the positive news the stock remains depressed and could fall further due to political and economic factors. Though the company is primarily domestic, the Chinese economy has already begun to slow in face the face of heightened geo-political tensions. Apple has seen sales of its flagship product decline precipitously as the Chinese Gross domestic product(GDP) growth slowed the last half of 2018. By all indications, it appears that trade negotiations will likely get tougher as the year unfolds. The US Department of State recently issued travel advisories that discourages US citizens from travelling to China. This action follows the earlier arrest of the CFO of Huawei who has strong ties to the Chinese government.

With all factors considered, it likely that TenCent could give back a significant portion of the gains generated since fiscal year 2016, and settle in the high 20s to low 30s. Long term we believe the company has solid fundamentals, and is in a strong position in the Chinese technology space. The company has solid Free cash flow generation, and a tried and tested management team that has owner-operator mentality.


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