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Peeling back the onion
3 September 2021
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The IEC have officially announced what some are calling a watershed moment for South Africa’s democracy. Our base case, and that shared by the majority of market participants, was for the ANC to win 45% of the vote, a coalition with the IFP and smaller parties formed, followed by business as usual.

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Current regulatory headwinds are putting pressure on the valuations of many Chinese tech giants by depressing valuations, and causing a distraction from the evident scale, dominance, and cash-generative nature of these businesses.

We remain confident in the growth potential of both Tencent and Alibaba.
When considering valuations, it is important to consider the core-earnings power of firms like Tencent and Alibaba, which also have large investment portfolios. To achieve this, we have stripped out their massive investment portfolios, and consequently, revealed the intrinsic valuation of the underlying operations. At this level current value is extremely attractive!

Tencent

Tencent has an extensive portfolio of internet-enabled businesses including social media, music streaming, e-commerce, online games, cloud computing, fintech, and payment systems.

Tencent is currently trading at HK$481.20, with their investment portfolio contributing a market value of HK$136.05/shr (29%).

Subtracting the market value of the investment portfolio, brings down the share price to HK$345.15; this represents the value the market is currently attributing to its underlying business. At these levels, the market is valuing the core business at a multiple of 17.2x earnings for a revenue stream that is growing north of 20%. Clearly the regulatory headline risks are pressuring the multiple at present, but we expect this risk to pass, and the value embedded in Tencent’s underlying business will yet again shine through.

Using a back-of-the-envelope calculation, we assume a continued 15% revenue growth for the next 5 years, as well as maintain a current 25% Free Cash Flow margin. We then apply a 20x multiple to that FCF, and discount it back to get a value of HK$424.18/shr for the underlying revenue. Layering the value of the investment portfolio on top, gets you to a forward valuation of HK$626.18/shr or a 30% upside from current levels.

Alibaba

Alibaba, “China’s Amazon”, is a dominant e-commerce marketplace retailer with a market share of approximately 60%. The company’s web portals also provide electronic payment services, shopping search engines, and cloud-computing services. Even with the hindrance of recent regulations, the degree to which this will harm their immense earnings power is low.

Alibaba is currently trading at US$162.29, with their investment portfolio contributing a market value of US$46.64 (28.7%).

Subtracting the market value of the investment portfolio, brings down the share price to US$118.58. This shows that the market is valuing the core business at a multiple of 11.9x earning for a revenue stream of approximately 22%.
Using a similar forward valuation as Tencent; we assume a 20% revenue growth and 20% FCF margin. This equates to a present value of US$283.52/shr for its underlying business. Adding the value of the investment portfolio gets us to an estimated total value per share for Alibaba of US$330.16/shr, representing 100% upside from current share price.Using a similar forward valuation as Tencent; we assume a 20% revenue growth and 20% FCF margin. This equates to a present value of US$283.52/shr for its underlying business. Adding the value of the investment portfolio gets us to an estimated total value per share for Alibaba of US$330.16/shr, representing 100% upside from current share price.
The point of this note is to demonstrate that these businesses have multiple dimensions, and market value is being delivered on several fronts. It is important to realise what the underlying business is being valued at in order to make an educated decision on what is currently being discounted into the share price. In the case of Tencent and Alibaba, we believe a significant amount of risk is already being priced in and if this current headline risk proves transitory, valuation for both could be significantly higher.