Tuesday, July 21, 2015

Tencent......10 cents is about what it's worth.....

A good friend and avid reader of this blog recently asked me to take a look at Tencent (HK-0700) "The most beloved eCommerce company on the planet".  At first blush this company looks like an amazing enterprise; Current market cap of almost US$200 Billion; 2014 Revenues of  nearly US$13 Billion growing at 30%.  Significant operating margins and profitability.  GAAP Net Income Available to shareholders for the year ended 12/31/14 was US$3.8 Billion, up 50% from 2013.  All of this accomplished in a slowing Chinese economy.  Amazing, isn't it?

All of the info referred to below comes from the 2015 Quarterly, 2014 & 2013 Annual Reports.

For those of you who aren't familiar with Tencent, they write software and video games, most of which are given away for free. Their leading products are QQ (free messaging), WeChat (a free chat app), QQ Music; QQ Mail, QQ Show (all free) as well as VIP services for a few RMB per month.  They also publish video games such as "Timi Match Everyday" and "Thunder Fighter" (40 million Accounts); "We Fly" (100 million Accounts) and "League of Legends" (7.5 million Users)  See: List of Product Monetization

Most of the applications are free downloads with VIP upgrades available for a fee.  Let's look at the revenue growth per Registered Subscription:

Value Added Services (VAS) in 2014 were CNY 63,310 (US$ 10.2 Billion) are relatively constant at about 80% of Total Revenue and growing at roughly 30% per year.  VAS makes up the lion's share of the company's revenue. The other 15%-20% of revenue is generated by Advertising, eCommerce and "Other" Services.  Interestingly, the number of paid subscriptions is actually decreasing, yet, the VAS revenue continues to rise, more than doubling in two years.  What the above numbers are telling us is that fewer people are actually interested in the Tencent services and games, but those who are, are quickly purchasing a much higher level of products and services. As I've said before in other posts, that pesky "law of large numbers" would render this trend improbable.

When I thought about these numbers for a minute, they seemed gigantic.  US$ 13 Billion for APP & Game sales?  After all, Nintendo only has Revenues of about $4.5 Billion.  They've been around for years and sell game hardware as well.  Sony PlayStation (Game & Network Services) Revenue is about US$ 10.5 Billion globally, again including hardware sales.  I'm guessing that there there might be something else included in Tencent revenues.

Now let's assume, rather than the bulk of Tencent's users consuming primarily "free" services, that ALL of the 82 million paying subscribers purchased ALL of the products and VIP services available to them. Based on Tencent's published, but incomplete metrics, here's what we might get.

In other words, as flawed as this top-side analysis may be due to a lack of granularity available from the Tencent Annual Report, even if every Subscriber purchased every product available at the highest subscriber rate disclosed, there is a US$ 3.3 Billion shortfall from "Projected Max Annual Revenue" and the Actual 2014 VAS Revenue of 2014.  So where does the rest of the Revenue come from?

The answer to this question lies in footnotes 10 and 11 of the 2014 Annual Report.  Beginning on page 90, The Notes describe the IFRS (International Financial Reporting Standards) requirements regarding the "Consolidation" and "Equity Method" of accounting for Controlled and Non-Controlled Businesses.  Simply put, based on a number of criteria, if control of another business is demonstrated, it's proper to consolidate assets, liabilities, revenues and expenses in their entirety.  I won't bother to get into the specific IFRS requirements for Consolidation, but I've pasted a very good Summary from Ernst & Young below. Generally, when management determines that they have obtained substantial voting, contractual or economic control, based on a number of subjective metrics and criteria, it's appropriate to "Consolidate" or "include" the proportionate share of the acquired business's Assets, Liabilities, Revenues and Expenses in the financial statements of the "Controlling" business.

On page 138 (Note 10 to the Consolidated Financial Statements) there are twelve (12) wholly owned, consolidated subsidiaries. Revenues/expenses/assets/liabilities are not disclosed.

One of the more curious subsidiaries, Tencent Asset Management, LLC was established in the BVI in 2004. Since the function, resources and operations of this business are not disclosed, we can only speculate about what this business actually does and what its holdings might be.  There have been numerous press releases describing the "non-IT" businesses Tencent is involved in, yet there is little, if anything described in the financial statements.  Wealth Management Products, Investments, Banking, Real Estate, etc. are all described by the financial press but missing from discussion in the financial statements.  Moreover, I'd suggest that the possibility exists that Tencent Asset Management, LLC is yet another device for Chinese insiders to move money off shore, out of the reach of regulators and authorities.

Here's a more complete Summary of what various sources have reported as Tencent "Investments" in 2014.






































Most of the above aren't discussed in the financial statements so it's impossible to determine how many of these investments, or how much Revenue associated with the $23.3 Billion total invested by all  "Joint Venture" Participants is actually "Consolidated" in the Tencent Financial Statements.  For example, note that Tencent is now involved in a Sinopec "Joint Venture" valued at $17.44 Billion to Market Petroleum Products on-line, yet it's not mentioned in the financial statements.  Based on the above, there could be rents, interest, investment income, transaction processing fees, etc. yet, everything is lumped into the nebulous category Value Added Services.  From an accountants perspective, it would be nice to see a columnar format showing the Revenue, Expenses and Profits of the major Consolidated entities rather than lump sum totals for Value Added Services. Without this presentation, the reader of the financial statements has no way to evaluate this rapidly evolving business.

Consolidation or "Buying" revenue......  

Management's explanation for the fantastic (i.e. unbelievable) revenue growth in 2014 is prominently listed on pg. 5 of the 2014 Annual report.
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Maybe I'm old school, but to me, this is the height of misrepresentation.  Management is making a clear and deliberate attempt to portray this huge revenue growth as organically generated by existing businesses, when in reality, according to their disclosures buried deep in the bowels of their financial statements, the core business revenue most likely shrank YOY.   There is no mention of  "Buying" (Consolidating) revenue by "investing" significant funds in unprofitable/un-auditable businesses. These disclosures should be front and center, yet, they first rear their ugly head on pg 138 of the Annual Report.  Management has taken every liberty and stretched the IFRS consolidation guidelines to the limit,  presumably because they know that the lap-dog analysts they've got assigned to the account never read or understand the footnotes anyway.

Equity Method "Investments" 

The section beginning on pg. 141 describes the entities included as Investments and accounted for under the "Equity" or "Non-Consolidated" Accounting Method and the related carrying values.  Again, I won't get into the rules for equity method accounting (See E&Y Summary)  Suffice it to say than when a business acquires a non-controlling interest in another business, the value of the investment is carried as a line-item asset, with a value to be determined under the IFRS Guidelines.























During the year ending 12/31/14 Tencent Acquired, interests in the above "Associates" as well as an additional US$ 2 Billion for a total increase in asset value of US$ 8.6 Billion.  Carrying Value of these businesses as of 12/31/14 was CNY 54,072 Million (US$ 8.7 Billion.) (pg. 141).  The Consolidated Associates Net Loss for the year was ($43 Million) .  Simply put, the businesses Tencent has "invested" in are losing money.  The carrying value of these "new" Associates is roughly a third of the total assets of the business.  They've levered-up and invested/wasted the money on these businesses. 

In a past life, when I was cutting my teeth as a junior auditor I had a crotchety old supervisor who always said "there are three ways to value assets.....LIFO, FIFO and SAY-SO.....we can't certify SAY-SO....harumph....harumph".  That said, here are a few reasons (none of them good) as to why all of these acquisitions and joint ventures have been made and are indeed a quintessential element of the Chinese e-Commerce playbook.

  1. They make the financials virtually un-auditable.  By investing in these businesses, company auditors have a difficult time valuing, or even determining the "Going Concern" basis of the "Investee" businesses.  Generally, the Public Accountants have no method or professional obligation to audit the books of the Consolidated of Investee entities.
  2. Valuation - under the "Equity Method "of accounting, step valuations get "re-valued" at each "step" providing an opportunity to revalue and "write up" the asset to fair/favorable value with every step.
  3. These investments and inherent lack of disclosure bloat the balance sheet and revenues, giving the business the appearance of being much larger than it actually is, making it nearly impossible for investors to determine what level of growth is real what's the result of Enron-esque accounting games. 
So, now we've established that Tencent's organic growth has slowed substantially and they've been buying up and consolidating businesses at an "Alibaba-like" pace.  The primary purpose of this accounting gamesmanship is to bolster top line growth in a blatant effort to convince Investors the business is growing when its's really not.

"Gain on Deemed Disposal" of Investees

On page 23 of the Annual Report Tencent discloses a "Gain on deemed disposal" of Investees of  5,054 RMB (US$ 815 Million)  The only noteworthy comment I can make here is that it's remarkable that they've not described this transaction at all.  You'd think they would at least consider a footnote describing what was "deemed" to be sold, the selling price, cost basis, and why/how a gain was booked since they are reporting a gain approaching a billion dollars.

Share Based Compensation Expense

Share Based Compensation Expense is described on page 23.  2,437 RMB (US$ 393 Million) for 2014 is roughly 3% of Revenue and 11% of Net Income.  This expense is significant and probably unnecessary to retain quality employees.


Summary

Let's compare Tencent to Alibaba from my prior "A Year in Review" post....It's the same playbook.  Bloated/Inflated Asset Values, Unnecessary Share Based Compensation, booking "Deemed Gains" on asset sales, expenses out of control, lack of disclosure and detail, and a constant stream of odd, unrelated acquisitions with the apparent, sole design/purpose being to take advantage of IFRS accounting conventions.

1/3rd of Tencent's balance sheet is "invested" in un-audit-able, il-liquid Chinese businesses that don't make money and are likely valued at the generally absurd levels of the Chinese equity markets.  Not to give anything away, but I'm also working on a post re: JD.com where sources inside the PROC are telling me that revenues are probably about a third overstated since JD.com requires their suppliers to buy back slow moving products on-line.  In other words, they record inventory returns and buy-backs as low/no margin Retail Sales rather than a return of inventory, significantly overstating both turnover and revenue. Again, this is just another convoluted effort to show fake organic growth.  These accounting shenanigans are apparently epidemic in Chinese ADR financial statements.

So again I ask, (please refer to my "India....the next super power" blog)  is it more likely that 800 million Chinese people are spending many hours a day playing "cool" smart phone games like "Everybody Pong Pong Pong", shopping on-line all night and chatting endlessly when they get home from their 14 hour work day at the Foxconn plant or steel mill?....or, as I've attempted to describe in this post, do you think it's at least plausible that the revenues and growth rate of Tencent might be more than a tad overstated?

Finally, as you might have heard if you've not been living under a rock, China's markets have entered bear territory and are off more than 30% from their peak established just a few weeks ago.  The only reason the carnage has slowed is that the government has generally made it "illegal" for many investors to sell shares and implemented the "SAY-SO" valuation method for underlying collateral.  SOE banks, brokerages and other institutions are currently required to fund the frozen markets, delay margin calls and roll-over loans.  There's a liquidity crunch solidly underway and every one of these large-cap eCommerce stocks is grotesquely intertwined with the fortunes of the others.  To paraphrase Warren Buffett, ..."it's only a matter of time until the tide goes out and we all find out who's been swimming naked."




Other Interesting/Relevant Links:

Revenue per product
http://www.tencent.com/zh-cn/content/ir/fs/attachments/ProductlistofTencent.pdf

Tencent 2013 Annual Report
http://www.tencent.com/en-us/content/ir/rp/2013/attachments/201302.pdf

Tencent 2014 Annual Report
http://www.tencent.com/en-us/content/ir/rp/2014/attachments/201402.pdf

Tencent 2015 1st Quarter
http://www.tencent.com/en-us/content/ir/news/2015/attachments/20150513.pdf

E&Y IFRS 10-11 - Equity Method & Consolidation
http://www.ey.com/Publication/vwLUAssets/Applying_IFRS_11/$FILE/Applying_IFRS_11.pdf

Acquisitions
https://www.techinasia.com/wechats-growing-empire-tencent-invested-acquired-2014/

WeChat vs WhatsApp
http://qz.com/179007/wechat-is-nothing-like-whatsapp-and-that-makes-it-even-more-valuable/

1.28 billion smart phones 95% penetration
http://www.forbes.com/sites/dougyoung/2015/01/15/smartphones-at-tipping-point-in-china/

Naspers
http://www.ft.com/intl/cms/s/0/82e365aa-1984-11e5-a130-2e7db721f996.html?ftcamp=traffic/partner/feed_headline/us_yahoo/auddev,traffic/partner/feed_headline/us_yahoo/auddev#axzz3eMzCE2Ad

Shanda Games - 20F
http://files.shareholder.com/downloads/ABEA-3EY0OF/378875410x0x823752/6D612778-28AB-4ABE-9DB3-90AED49A9944/2014-Annual_Report.pdf

Netease - 20F
https://www.sec.gov/Archives/edgar/data/1110646/000110465915030142/a15-4743_120f.htm

ChangYou 20F
https://www.sec.gov/Archives/edgar/data/1458696/000119312515071853/d876740d20f.htm

10 most popular chat apps in the world
http://readwrite.com/2014/03/06/10-biggest-popular-mobile-messaging-apps-world-whatsapp

Wealth Management
http://usa.chinadaily.com.cn/epaper/2014-01/20/content_17246502.htm

Investments
https://www.crunchbase.com/organization/tencent/investments

Acquisitions
https://www.crunchbase.com/organization/tencent/acquisitions

Bitauto
http://www.reuters.com/article/2015/01/09/us-bitauto-holdings-deals-jd-com-tencent-idUSKBN0KI1GD20150109

Dianping
http://www.tencent.com/en-us/content/ir/an/2014/attachments/20140219.pdf






Monday, July 20, 2015

A little more on India.....

I wanted to take a moment to thank many of you for your wonderful commentary on my  "India" post a few weeks ago.  As always, I appreciate your feedback. I also want to take a minute to post a couple of comments from a colleague and friend, Dr. Agrawal, who is a professor at one of our Universities here in Ohio.  Here is the text of his e-mail:

"Very nice and accurate observations. On the top of it nicely described. I would suggest to add few pictures from modern India, which, I will share if you like, you may not have visited those places. These pictures will probably support your theory for India- the emerging global power. Its up to you.  Please allow me to share your write-up with my University students, which I am taking in Dec -2015. Our 3-credit course is also on Global Health and Emerging India. Very well done."
Of course, the intent of my post was to describe the enormous potential just below the surface in India coupled with how truly difficult is to conduct e-commerce and logistics in Asia.  I wanted to visually illustrate the roadblocks that need to be overcome before real growth and productivity can be achieved in much of Asia. That said, I'm posting the above referenced pictures in additional support of my "India....the next economic superpower" thesis.  I hope you enjoy the pictures that Dr. Agrawal forwarded to me....they truly are beautiful.