ANCHOR REPORT Tencent Holdings: Blue sky or hard - Paul Gillis

110 Pages·2012·2.79 MB·English

Equity Research

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Tencent Holdings: Blue sky or hard landing?

Potential mindshare losses, imitative product
November 15, 2012
offerings to impact growth - REDUCE
Research analysts
Our key argument is Tencent's gaming success is not transferable to other China Internet & New Media
businesses. Gaming for Tencent has been about imitation and distribution,
Jin Yoon - NIHK
whereas areas like e-commerce require networking impact to succeed. [email protected]
[phone]
Given its ~USD9bn revenue base for 2013, are Weixin, online video and
targeted ads going to move the needle? Xiaoyan Zhang - NSI
[email protected]
When we took a bearish view a year ago, we argued that growth would [phone]
have to slow due to high base, declining margins and mindshare losses.
Yong Wang - NIHK
[email protected]
Over the intervening quarters, the company has not surprised us on
[phone]
earnings, and yet the stock price has soared. Can new product offerings

offset the potential slowdown in core business?

While scarcity value likely helped Tencent to outperform, we acknowledge
the premium put on stability. We raise our TP to HKD180 but stick with our
call and note 3Q earnings finally surprised consensus on the downside.

Key analysis in this anchor report includes:
 Investors worry about the mobile threat to Facebook, Google and
Baidu, so why isn’t mobile seen as a threat to Tencent?
 Why hasn’t SNS advertising taken off in China as in the West?
 E-Commerce: an opportunity or a threat?
See Appendix A-1 for analyst certification, important disclosures and the status of non-US analysts.
Tencent Holdings
0700.HK 700 HK

EQUITY RESEARCH
INTERNET & NEW MEDIA

Blue sky or hard landing? November 15, 2012

Rating Reduce
Potential mindshare losses, Remains

Target price
imitative product offerings to Increased from 146.00 HKD 180.00
Closing price
impact growth November 13, 2012 HKD 270.20
Potential downside -33.4%

REDUCE: Product success does not guarantee business success Anchor themes
Our key argument is that Tencent's gaming success is not transferable to Given a large increase in the
other businesses. Gaming for Tencent has been about imitation and number of companies and
distribution, not likely to equal such success that requires networking impact services in the gaming industry,
such as e-commerce. companies are under
Sometimes a stock is more than a business: TP lifted to HKD180 increasing pressure on revenue
When we called REDUCE on Tencent a year ago, we argued that growth growth and margins.
would have to slow off a very large base. Indeed, over the intervening
Nomura vs consensus
quarters, the company has not surprised us on earnings, and yet the stock
price has soared this year. While we think some of this reflects scarcity Our EPS estimate for FY13F is
value, we acknowledge that investors are happy to pay a premium for 4.5% below consensus. We
stable performance. We raise our TP to HKD180 but stick with our believe consensus margin
REDUCE call and note that the 3Q12 earnings release has finally surprised estimates will have to be rolled
consensus on the downside. back as cost pressures loom.

We’ve done lots of homework
Research analysts
 Can Tencent sustain the growth in gaming business to support margins
and cash flow as competition intensifies within gaming coupled with
China Internet & New Media
gaming’s potential mindshare loss to other online mediums?
Jin Yoon - NIHK
 Investors worry about the threat from mobile platforms to Facebook, [email protected]
[phone]
Google and Baidu, so why isn’t mobile seen as a threat to Tencent?
Xiaoyan Zhang - NSI
 Why haven’t SNS ads taken off in China compared to that of the West?
[email protected]
[phone]
 E-Commerce: an opportunity or a threat?
Yong Wang - NIHK
Valuation: Lift TP to HKD180 [email protected]
We lift our TP to HKD180 from HKD146, representing 15.4x of our FY13F [phone]
EPS of HKD11.7, or a PEG of 0.76x on FY12-14F EPS CAGR of 20.3%.

31 Dec FY11 FY12F FY13F FY14F
Currency (CNY) Actual Old New Old New Old New
Revenue (mn) 28,496 43,865 44,168 54,907 57,435 64,608 68,909

Reported net profit (mn) 10,203 12,666 12,659 14,851 15,161 17,147 17,643
Normalised net profit (mn) 10,940 13,816 13,878 16,396 16,759 18,983 19,585
FD normalised EPS 5.89 7.43 7.45 8.81 9.00 10.20 10.52
FD norm. EPS growth (%) 27.5 26.1 26.6 18.7 20.8 15.8 16.9
FD normalised P/E (x) 37.8 N/A 28.6 N/A 23.1 N/A 19.8
EV/EBITDA (x) 27.1 N/A 18.7 N/A 14.6 N/A 12.0
Price/book (x) 13.9 N/A 9.3 N/A 6.6 N/A 5.0
Dividend yield (%) 0.3 N/A 0.4 N/A 0.4 N/A 0.5
ROE (%) 40.1 35.7 35.6 30.0 30.5 26.1 26.5
See Appendix A-1 for analyst
Net debt/equity (%) net cash net cash net cash net cash net cash net cash net cash certification, important
Source: Company data, Nomura estimates disclosures and the status of
non-US analysts.
Key company data: See page 2 for company data and detailed price/index chart.
Nomura | Tencent Holdings November 15, 2012

Key data on Tencent Holdings
Income statement (CNYmn)  Relative performance chart (one year) 
Year-end 31 Dec FY10 FY11 FY12F FY13F FY14F
Revenue 19,646 28,496 44,168 57,435 68,909
Cost of goods sold -6,320 -9,928 -18,142 -24,522 -30,377
Gross profit 13,326 18,568 26,026 32,913 38,532
SG&A -2,950 -5,357 -8,688 -12,119 -14,333
Employee share expense
Operating profit 10,376 13,211 17,338 20,794 24,199

EBITDA 11,155 15,145 20,590 25,109 29,788
Depreciation -779 -1,934 -3,252 -4,315 -5,590 Source: ThomsonReuters, Nomura research
Amortisation  
EBIT 10,376 13,211 17,338 20,794 24,199 (%) 1M 3M 12M
Net interest expense -1 36 -384 -384 -384 Absolute (HKD) 4.4 18.3 71.3
Associates & JCEs Absolute (USD) 4.4 18.4 72.1
Other income 76 -190 -67 -67 -67 Relative to index 3.6 12.9 66.8
Earnings before tax 10,451 13,056 16,887 20,343 23,747 Market cap (USDmn) 64,962.1
Income tax -1,798 -1,874 -2,899 -3,458 -4,037 Estimated free float (%) 50.7
Net profit after tax 8,653 11,182 13,988 16,884 19,710 52-week range (HKD) 281/139.8
Minority interests -64 -65 -125 -125 -125 3-mth avg daily turnover 96.69
(USDmn)
Other items -7 -176 15 0 0 Major shareholders (%)
Preferred dividends Naspers 34.5
Normalised NPAT 8,582 10,940 13,878 16,759 19,585 Huateng Ma 10.9
Extraordinary items -529 -737 -1,218 -1,598 -1,942 Source: Thomson Reuters, Nomura research
Reported NPAT 8,054 10,203 12,659 15,161 17,643
Dividends -866 -1,125 -1,388 -1,676 -1,959
Transfer to reserves 7,188 9,078 11,272 13,486 15,685
Notes 

Valuation and ratio analysis
Reported P/E (x) 54.1 40.6 31.3 25.5 21.9
Normalised P/E (x) 50.7 37.8 28.6 23.1 19.8
FD normalised P/E (x) 50.7 37.8 28.6 23.1 19.8
FD normalised P/E at price target (x) 33.8 25.2 19.0 15.4 13.2
Dividend yield (%) 0.2 0.3 0.4 0.4 0.5
Price/cashflow (x) 35.4 31.0 16.4 14.5 13.1
Price/book (x) 19.5 13.9 9.3 6.6 5.0
EV/EBITDA (x) 38.7 27.1 18.7 14.6 12.0
EV/EBIT (x) 41.6 31.1 22.2 17.7 14.7
Gross margin (%) 67.8 65.2 58.9 57.3 55.9
EBITDA margin (%) 56.8 53.1 46.6 43.7 43.2
EBIT margin (%) 52.8 46.4 39.3 36.2 35.1
Net margin (%) 41.0 35.8 28.7 26.4 25.6
Effective tax rate (%) 17.2 14.4 17.2 17.0 17.0
Dividend payout (%) 10.8 11.0 11.0 11.1 11.1
Capex to sales (%) 7.6 14.2 13.3 13.3 13.3
Capex to depreciation (x) 1.9 2.1 1.8 1.8 1.6
ROE (%) 47.2 40.1 35.6 30.5 26.5
ROA (pretax %) 56.3 38.0 32.9 30.0 28.5

Growth (%)
Revenue 57.9 45.0 55.0 30.0 20.0
EBITDA 62.1 35.8 35.9 21.9 18.6
EBIT 63.6 27.3 31.2 19.9 16.4
Normalised EPS 55.5 27.5 26.6 20.8 16.9
Normalised FDEPS 55.5 27.5 26.6 20.8 16.9

Per share
Reported EPS (CNY) 4.33 5.49 6.80 8.14 9.48
Norm EPS (CNY) 4.62 5.89 7.45 9.00 10.52
Fully diluted norm EPS (CNY) 4.62 5.89 7.45 9.00 10.52
Book value per share (CNY) 12.03 15.99 22.97 31.45 41.32
DPS (CNY) 0.48 0.62 0.76 0.92 1.07

Source: Company data, Nomura estimates

2
Nomura | Tencent Holdings November 15, 2012

Cashflow (CNYmn)   
Year-end 31 Dec FY10 FY11 FY12F FY13F FY14F Notes 
EBITDA 11,155 15,145 20,590 25,109 29,788
Change in working capital -4,490 -2,465 -2,620 -2,218 -1,919
Other operating cashflow 5,654 678 6,162 3,730 1,668
Cashflow from operations 12,319 13,358 24,131 26,620 29,538
Capital expenditure -1,488 -4,046 -5,864 -7,626 -9,149
Free cashflow 10,831 9,312 18,267 18,995 20,389
Reduction in investments -326 -3,255 67 67 67
Net acquisitions -269 -1,444 0 0 0
Reduction in other LT assets -4,257 -2,033 -3,753 -3,177 -2,748
Addition in other LT liabilities 323 5,565 3,593 3,041 2,630
Adjustments -5,998 -10,142 -10,441 -8,868 -7,632
Cashflow after investing acts 304 -1,997 7,732 10,057 12,706
Cash dividends -639 -838 -1,125 -1,388 -1,676
Equity issue -345 -1,373 0 0 0
Debt issue 5,097 6,584 0 0 0
Convertible debt issue
Others -52 -172 0 0 0
Cashflow from financial acts 4,060 4,201 -1,125 -1,388 -1,676
Net cashflow 4,365 2,204 6,608 8,670 11,030
Beginning cash 6,044 10,408 12,612 19,220 27,889
Ending cash 10,408 12,612 19,220 27,889 38,919
Ending net debt -5,109 -4,613 -11,220 -19,890 -30,920
Source: Company data, Nomura estimates

Balance sheet (CNYmn) 
As at 31 Dec FY10 FY11 FY12F FY13F FY14F Notes 
Cash & equivalents 10,408 12,612 19,220 27,889 38,919
Marketable securities 0 0 0 0 0
Accounts receivable 1,715 2,021 3,132 4,073 4,887
Inventories 0 0 0 0 0
Other current assets 13,250 20,871 29,630 37,046 43,459
Total current assets 25,374 35,503 51,982 69,008 87,265
LT investments 1,145 4,400 4,333 4,266 4,199
Fixed assets 3,947 6,296 10,101 14,574 19,349
Goodwill
Other intangible assets 573 3,780 3,532 3,599 3,859
Other LT assets 4,791 6,825 10,578 13,755 16,503
Total assets 35,830 56,804 80,526 105,202 131,176
Short-term debt 5,299 7,999 7,999 7,999 7,999
Accounts payable 1,380 2,244 3,478 4,523 5,427
Other current liabilities 6,343 10,940 16,956 22,049 26,454
Total current liabilities 13,022 21,183 28,434 34,572 39,881
Long-term debt
Convertible debt
Other LT liabilities 967 6,533 10,125 13,167 15,797
Total liabilities 13,989 27,716 38,559 47,739 55,678
Minority interest
Preferred stock 0 0 0 0 0
Common stock 1,101
Retained earnings 17,090 26,168 37,440 50,926 66,610
Proposed dividends 866 1,125 1,388 1,676 1,959
Other equity and reserves 2,784 1,795 3,139 4,862 6,929
Total shareholders' equity 21,841 29,088 41,967 57,463 75,498
Total equity & liabilities 35,830 56,804 80,526 105,202 131,176

Liquidity (x)
Current ratio 1.95 1.68 1.83 2.00 2.19
Interest cover 12,381.4 na 45.1 54.1 63.0

Leverage
Net debt/EBITDA (x) net cash net cash net cash net cash net cash
Net debt/equity (%) net cash net cash net cash net cash net cash

Activity (days)
Days receivable 27.4 23.9 21.4 22.9 23.7
Days inventory 0.0 0.0 0.0 0.0 0.0
Days payable 60.0 66.6 57.7 59.5 59.8
Cash cycle -32.6 -42.7 -36.4 -36.7 -36.0
Source: Company data, Nomura estimates

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Nomura | Tencent Holdings November 15, 2012

Contents

5 Executive Summary

6 Where we have been wrong?

9 Valuations

9 Maintain Reduce; TP lifted to HKD180

12 Introduction

16 Tencent seems to have a talent for imitating
products, but not business

16 Gaming

29 Gaming appears to be a losing game

30 Competition within gaming

40 Potential mindshare loss

43 Online video

46 Mobile

60 Tencent’s Open Platform

65 Assessing the SNS opportunity for Tencent

69 Implications for China

85 Back to the Future

104 Appendix A-1

4
Nomura | Tencent Holdings November 15, 2012

Executive Summary
Tencent seems to have a talent for copying products but not business
Tencent’s growth story over the last four years has been via licensed games and self-
developed games that look very similar to those of its competitors. While the company
has demonstrated success in launching products similar to those of its peers as online
gaming requires little networking impact, launching similar businesses, ie, online video,
Weibo, e-commerce, like those of its peers may prove to be more challenging.
Mindshare loss likely imminent. Poor people, rich people, everyone has one thing in
common. People only have 24 hours a day. With Tencent stretching itself into business
areas such as mobile, third party-open platform, online video video, Weibo, etc, we can
see potentially significant mindshare loss from high-APRU generating products like
online gaming to low-ARPU generating products like online video or Weixin. In 2Q12, we
saw for the first time where PCU for IM has declined sequentially. We blame this on the
mindshare gains on the mobile, in particular Weixin.
Online gaming likely to have peaked in 1Q12
Based on our estimates, gaming peaked in 1Q12. Given the progressively saturated
market with an expanding number of gaming titles in China, as well as mindshare loss
from the proliferation of alternative entertainment sources on the Internet, it is likely to be
increasingly difficult for individual games to gain significant traction. We question the
ability of industry players to consistently return added profitability given: 1) increased
competition within gaming and 2) expanding competition from alternative media.
Furthermore given the competition, games in the pipeline may not be enough to offset
the potential declines in core games.
SNS advertising unlikely to work in China
Given the lack of data integrity and short history of user behavior tracking in China,
target advertising is likely to be difficult on social networking sites in the near term. As
well, we do not believe that Tencent’s GDT is as robust as Facebook’s FBX, hence
impact to revenues may be minimal in the near term. Less time commitment to social
networking sites and a younger Internet population than in western countries adds
incremental challenges to the industry in China, in our view.
Mobile opportunity appears overblown
Investors appear quite concerned about threats from the mobile platform for companies
like Google, Facebook and Baidu. That said, why isn’t mobile also seen as a threat to
Tencent? While we are positive on the long-term prospects of Weixin, we believe that
regulatory threats remain and mindshare losses from higher revenue generating PC
applications remain a concern for Tencent.
Back to the Future
E-commerce today in China resembles the same growing industry in the US in the late
1990s. Companies undercut pricing to remain competitive, trying to be the last to survive.
Similar to what we have witnessed in the last decade in more developed markets, most
Chinese e-commerce players appear to have significantly under-invested in fulfilment
capacity. Given that Tencent is at least five years behind industry leaders like 360BUY,
who remain unprofitable today, we believe this will be a losing battle for shareholders
and the industry competitive landscape seems unlikely to ease in the next few years.
Not moving the needle
Tencent's greatest challenge remains its large revenue base, in our view. Given
~USD9bn in revenues that we forecast for next year, we believe it is difficult for
incremental products to move Tencent's top-line growth. Further, based on our
observations, many new products are incremental only to the top line, yet significantly
dilute margins.

5
Nomura | Tencent Holdings November 15, 2012

Where we have been wrong?
Tencent’s share price has done well during the past few months, although its non-GAAP
operating margin contracted to 38.4% in 3Q12 from 53.7% in 2Q10 and bottom line
growth slowed to 28.2% y-y in 3Q12 vs 60.7% y-y in 2Q10, as we had previously
forecast. Why? First, we believe Tencent's gaming business, although slowing in growth,
has done well during the past few quarters, with the steady performance of legacy
games such as CF and DnF and incremental contribution from new games such as LoL,
which recorded PCU of 2mn in Sep 2012. However, we believe this should have been
expected by the market. Second, we believe Tencent enjoys a significant scarcity value
trading on the Hong Kong exchange, which has much lower turnover compared to other
major stocks exchanges eg, NYSE, NASDAQ, LSE, etc.
The natural de-rating process of Internet companies
For technology and Internet companies, de-rating tends to occur when a company's top-
line growth slows and its margins contracts. When a new company emerges in a new
area, one growth driver is its competitive advantages, which enable it to eliminate
competitors and grab market share quickly. However, when the company has a
dominant market share, ie, market sharing gaining could no longer serve as a significant
growth driver, we believe the only way the company could grow is if the market size gets
bigger. However, the market is usually growing at a slower rate after years of growth as
the base effect kicks in. On the other hand, margin contraction happens as cost growth is
outpacing revenue growth as most costs are recurring in nature, mostly in headcounts
costs. Meanwhile, companies usually seek other areas for expansion, which incurs
significant initial investment to add further pressure on margins and usually has limited
top-line contribution in the near term. We examine the de-rating process of Ebay and
Google below. As show below, Ebay's P/E ratio de-rated from 50.3 in 1Q05 to 7.7 in
1Q09 and had remained at low teens levels since, coupled with top line growth slowed
from 40s y-y to 20s and operating margin contracted from high 30s to high 20s. Similarly,
Google's P/E, as shown below, was de-rated from 30s in 2005 to low teens in the last
several years. This is the typical trajectory we have seen for ex-growth Internet
companies.

Fig. 1: Ebay: P/E vs revenue growth Fig. 2: Ebay: P/E vs non-GAAP OPM

60 50%
Average Forward PE (LHS) 60 Average Forward PE (LHS) 40%
50 y-o-y growth (RHS) 40% Non GAAP Operating Margin (RHS) 38%
50
q-o-q growth (RHS) 36%
30%
40 40 34%
20% 32%
30 30 30%
10%
28%
20 20
0% 26%
24%
10 -10% 10
22%
0 -20% 0 20%
E E E E E E E E E E E E E E E E E E E E E E E E E E E E E E E E
5 5 6 6 7 7 8 8 9 9 0 0 1 1 2 2 5 5 6 6 7 7 8 8 9 9 0 0 1 1 2 2
0 0 0 0 0 0 0 0 0 0 1 1 1 1 1 1 0 0 0 0 0 0 0 0 0 0 1 1 1 1 1 1
Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q
1 3 1 3 1 3 1 3 1 3 1 3 1 3 1 3 1 3 1 3 1 3 1 3 1 3 1 3 1 3 1 3
Source: Company data, Bloomberg, Nomura estimates Source: Company data, Bloomberg, Nomura estimates

6
Nomura | Tencent Holdings November 15, 2012

Fig. 3: Google: P/E vs revenue growth Fig. 4: Google: P/E vs non-GAAP OPM

Average Forward PE (LHS)
45 120% 45 45%
y-o-y growth (RHS)
40 40 40%
q-o-q growth (RHS) 100%
35 35%
35
80% 30 30%
30
25 60% 25 25%
20 20%
20 40%
15 15%
15
20% 10 10%
10 Average Forward PE (LHS)
5 5%
0%
5 Non GAAP Operating Margin (RHS)
0 0%
0 -20% E E E E E E E E E E E E E E E E
5 5 6 6 7 7 8 8 9 9 0 0 1 1 2 2
E E E E E E E E E E E E E E E E 0 0 0 0 0 0 0 0 0 0 1 1 1 1 1 1
5 5 6 6 7 7 8 8 9 9 0 0 1 1 2 2 Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q
0 0 0 0 0 0 0 0 0 0 1 1 1 1 1 1
Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q 1 3 1 3 1 3 1 3 1 3 1 3 1 3 1 3
1 3 1 3 1 3 1 3 1 3 1 3 1 3 1 3
Source: Company data, Bloomberg, Nomura estimates Source: Company data, Bloomberg, Nomura estimates

Where we have been wrong - the scarcity value
We had expected Tencent to follow the same pattern of Ebay and Google among other
ex-growth Internet companies. However, trading multiples for Tencent have picked up in
the last few months while the fundamentals of the company did not experience
significant changes, based on our observations.

Fig. 5: Tencent: P/E vs revenue growth Fig. 6: Tencent: P/E vs non-GAAP OPM

Average Forward PE (LHS)
60% 35
35 y-o-y growth (RHS) 140%
q-o-q growth (RHS)
30
30 120% 50%
100% 25
25 40%
80%
20 20
60% 30%
15 15
40%
20%
10 10
20%
Non GAAP Operating Margin (LHS)
5 0% 10% Average Forward PE (LHS) 5
0 -20% 0% 0
Q05E Q05E Q06E Q06E Q07E Q07E Q08E Q08E Q09E Q09E Q10E Q10E Q11E Q11E Q12E Q12E Q05E Q05E Q06E Q06E Q07E Q07E Q08E Q08E Q09E Q09E Q10E Q10E Q11E Q11E Q12E Q12E
1 3 1 3 1 3 1 3 1 3 1 3 1 3 1 3 1 3 1 3 1 3 1 3 1 3 1 3 1 3 1 3
Source: Company data, Bloomberg, Nomura estimates Source: Company data, Bloomberg, Nomura estimates

As a large-cap company with apparently good liquidity, positive cash flow and good
corporate governance, Tencent enjoys a significant scarcity value on the Hong Kong
exchange; there are not many stocks traded on the HK exchange that have the above-
stated positive characteristics. Indeed, the liquidity of the Hong Kong exchange is
relatively low compared to other major stock exchanges. We examine the liquidity of the
HK exchange and Tencent compared to its peers, respectively, as below.

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Nomura | Tencent Holdings November 15, 2012

Fig. 7: Liquidity of major stock exchanges

Stock exchange # of listings Market Cap (USD bn) Daily traded value (USD mn)
NYSE 2 ,019 1 3,056 9 3,484
NASDAQ 2 ,479 4 ,543 4 8,607
LSE 2 ,478 3 ,500 6 ,668
TSE 2 ,413 3 ,342 1 2,781
HKSE 1 ,546 3 ,145 4 ,119
Note: daily traded value is based on six months average; as of Nov 13 2012
Source: Bloomberg, Nomura research

Fig. 8: Liquidity comparison: Tencent vs. global peers

Company Listed exchange Price Market Cap (USD bn) Daily traded value (USD mn)
Apple NASDAQ 542.90 5 10.7 1 0,189
Google NASDAQ 659.05 2 16.2 1 ,743
Amazon NASDAQ 226.60 1 02.6 7 86
Microsoft NASDAQ 27.09 2 28.0 1 ,305
Tencent HKSE 270.20 63.6 99
Baidu NASDAQ 98.60 34.5 556
Sina NASDAQ 53.90 3.6 138
Sohu NASDAQ 38.90 1.5 27
Netease NASDAQ 52.32 6.8 41
Note: daily traded value is based on six months average; as of Nov 13 2012
Source: Bloomberg, Nomura research

It is noteworthy that on the Hong Kong exchange, while having comparable market cap
with LSE and TSE, has significantly lower daily traded value, ie, 40% lower than LSE
and 68% lower than TSE, and Apple's daily traded value is more than 2x of that of the
entire Hong Kong exchange. Moreover, Tencent's daily traded value is only 20% of
Baidu's and is even lower than Sina's, whose market cap is 6% of Tencent's.
We further examine the number of companies that meets the following criteria in the
major exchanges: large market cap (>USD10bn), positive cash flow and liquid (daily
turnover > USD10mn) and find out that stocks that meet our criteria outperformed
respective indexes year-to-date.

Fig. 9: Number of stocks that meet our criteria

Stock exchange # of total listing stocks # of stocks meet criteria Average YTD performance Index YTD performance Outperformance
NYSE 2 ,019 2 28 15.9% 9.3% 6.6%
NASDAQ 2 ,479 62 18.6% 10.7% 7.9%
LSE 2 ,478 46 14.9% 3.8% 11.1%
TSE 2 ,413 54 6.1% 2.6% 3.5%
HKSE 1 ,546 36 19.9% 15.8% 4.1%
KRX 9 12 12 11.7% 3.4% 8.3%
Note: Note: Index used: S&P 500 for NYSE; NASDAQ Composite for NASDAQ; FTSE 100 for LSE; Nikkei for TSE; HSI for HKSE and KOSPI for KRX; as of Nov 13 2012
Source: Bloomberg, Nomura research

Hence, we believe that Tencent enjoys a significant scarcity value, given the lack of liquidity
of Hong Kong exchange. One other company that enjoys this benefit is NHN in Korea, in our
view. NHN is the largest Internet company in Korea in terms of market capitalization. The
company has been traded at high teens / low 20s PE multiples during the last three to four
years, while its EPS CAGR was only 2.5% from 2010 to 2012. Note that there are only 12
stocks that have large market cap, are cash flow positive and liquid, we believe that the
scarcity value has given a premium to the trading multiples of the company.

8
Nomura | Tencent Holdings November 15, 2012

Fig. 10: NHN: P/E band Fig. 11: NHN: PEG band
Price(KRW) Price (KRW)
Average P/E=19.0x
450,000 800,000
Highest P/E=30.6x
400,000 Lowest P/E=11.7x 30x 700,000 Average PEG=2.17x 3.0x
Highest PEG=7.51x
Current P/E=19.3x
350,000 25x 600,000 Lowest PEG=0.90x 2.5x
300,000 Current PEG=1.08x
20x 500,000 2.0x
250,000
400,000
200,000 15x 1.5x
300,000
150,000 10x
200,000 0.9x
100,000
50,000 100,000
0 0
88889999000011112222 88889999000011112222
00000000111111111111 00000000111111111111
Jan-Apr-Jul-Oct-Jan-pr-AJul-Oct-Jan-pr-AJul-Oct-Jan-Apr-Jul-Oct-Jan-pr-AJul-Oct- Jan-Apr-Jul-Oct-Jan-Apr-Jul-Oct-Jan-Apr-Jul-Oct-Jan-Apr-Jul-Oct-Jan-Apr-Jul-Oct-
Source: Bloomberg, Nomura research Source: Bloomberg, Nomura research

Valuations
Maintain Reduce; TP lifted to HKD180
We maintain our REDUCE rating and lift our TP to HKD180. While the company appears
to have been historically successful at imitating gaming products, it seems to now be
facing a deflationary period in gaming; as such, success is likely to be harder to achieve
in future periods. An increasingly competitive landscape in the Internet industry in China
is very likely to contribute much to mindshare loss for Tencent's users. Based on our
estimates, gaming has peaked in 1Q12 and going forward hit games are much less likely
to come by, thereby offering Tencent fewer successful models to imitate.
Based on our observations, it is unlikely that Tencent's other Internet products will speak
to a re-rating story for the company. In our opinion, Tencent's expertise does not rest in
imitating business lines demanding a large networking effect. Furthermore, we do not
believe that online gaming, open platform or even online ads will move the needle in the
near term. Also, Tencent's current attempts at SNS and ecommerce are unlikely to bear
fruit in the near term. We believe that lack of information integrity, low user engagement,
and younger user demographics makes targeted advertising significantly challenging for
Tencent. In addition, based on our observations, Tencent's e-commerce businesses are
likely to warrant much capital spending with little opportunity for profit in the years to
come.
Estimate Revisions
We revise our FY12F revenue to CNY44.2bn (+55.0% y-y) from CNY43.9bn (+53.9% y-
y) previously, largely due to stronger-than-expected contribution from advertising and e-
commerce sectors. We lower our FY12F gross margin estimate to 58.9%, compared to
our previous forecast of 59.1%, due to higher revenue contribution from e-commerce
associated with low gross margin. Our FY12F non-GAAP operating margin is adjusted
slightly to 39.3%, from 39.0% previously. We slightly raise our FY12F non-GAAP diluted
EPS to CNY7.45 from CNY7.43, along with our revised non-GAAP operating margin.
Our FY13F revenue goes to CNY57.4bn (+30.0% y-y) from CNY54.9bn (+25.2% y-y).
However, we lower our FY13F non-GAAP operating margin estimates by 40bps to
36.2% from 36.6% previously, as we believe the growth of e-commerce business will
continue to pressure margins. Our FY13F non-GAAP EPS was revised to CNY9.00 from
CNY8.81 previously. Earnings are likely to continue to de-rate, as we believe gaming is
not a very scalable business and margins should continue to erode as management
continues to invest heavily in new business ventures, eg, e-commerce, online video, and
micro-blogs etc, which are likely to be margin-dilutive.
On the valuation front, we would compare Tencent with Baidu, Sina, Sohu, Netease and
Google among its peer group, given its leadership position in social networking and in

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