Equity Valuation & Analysis Report

1 - Equity Valuation & Analysis Report introduction. Executive summary Tencent is a Chinese internet conglomerate engaging in internet valued added services (IVAS), mobile valued added services (MVAS) and online advertising and e-commerce. The internet services industry in China is at the growing stage due to technological advances leading to higher internet and mobile penetration within the country at a lower cost, as well as the strong economic growth upon China’s admission to the World Trade Organization (WTO).

Tencent’s most famous products include QQ (instant messenger), Qzone (social networking service) and QQ. com (internet portal) and 3G. QQ. COM (WAP portal) in which Tencent enjoys a leading position in the China market. The key success factors of Tencent are its large user base and strong R&D capability, which enable Tencent to offer a highly diversified product portfolio that locks-in existing users and engages potential ones.

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However, the increasing competitive pressure on a domestic and global scale, possible incapability to keep up with technological advances and breaking up with mobile telecommunication services providers provide additional business risks to Tencent. This study intends to provide a comprehensive analysis on the financial statements and disclosure of Tencent, while its profitability potential and valuation using conventional approaches such as the Free Cash Flow to Equity (FCFE) method would be provided.

Further, the study also provides readers with a brief description on the factors beyond financials that investors have to pay attention before making any investment decision. The results using FCFE showed that Tencent’s share price should be HK$247, which is 39% lower that the closing stock price of Tencent on 30 September 2013 (i. e. HK$406). With regards to the valuation results, the following recommendations are proposed for: (1)Existing investors: Sell Tencent’s shares at the moment because it is over-valued from the previous anslysis.

(2)Potential investors: Stay away from Tencent’s shares because there may be better choices in the market. 2. 0Industry overview Tencent has engaged in the internet service industry of China (PRC), which has a wide scope ranging from multimedia, social network services (SNS) and online games, online advertising and e-commerce etc. Among all other factors, influence from policy, economy, society, technology and regulations would be the main driving force for the development of the industry from a macroscopic point of view.

Given the wide spectrum of the internet service industry, it may not be so easy to provide an individual macroscopic analysis of each component in the industry. However, since each of these components is in the growth phrase and requires the similar internet and mobile telecommunication infrastructure for operations, the subsequent discussion would be made for the whole bundle instead of individually. Internet penetration and users have experience strong growth in recent years (see Exhibit 2. 0.

1), such growth is believed to remain strong due to technological advances together with the strong economic growth in PRC (see Exhibit 2. 0. 2) and drives up the demand for internet-related services. The strict information control in PRC has facilitated the growth of domestic participants while these participants have benefited from the support of the PRC government in general as well as their Chinese user interfaces, which makes domestic participants occupying the major part of the pie [except for Yahoo and Google, for example, upon PRC’s admission to the World Trade Organization (WTO) in 2001].

Participants may also take the advantage of weak enforcement of intellectual property protection, e-commerce and anti-trust laws and regulations to expand their businesses apart from their successful business strategies, which resulted in the emergency of giants like Baidu (online search engine), Tencent (instant messenger) and Alibaba (e-commerce platform). As a result, the threat of new entrant is moderate at the moment because of the user lock-in effect and dominant market position enjoyed by existing giants, which constitutes high entry barrier for potential entrants.

The threat of substitutes in the industry is rather low at the moment due to the user lock-in effect and dominant market position enjoyed by existing giants, resulting in a higher switching cost and hence a relatively lower bargaining power of buyers. The bargaining power of suppliers, on the other hand, could be considered moderate for the time being due to their good reliance on vendors to provide develop and maintain high-quality online business interfaces.

From the above discussion, the competition within the industry is rather moderate at the moment and the industry/ market is still growing that offers ample development opportunities for and thus attractive to current players, especially the dominant ones. However, one should note that the internet service industry is highly dynamic due to technological advances and changes in user preferences that the impact of each of the above forces and industry attractiveness changes from time to time, for instance, as shown in Table 2. 0. 1 below: NowNear Future Threat of new entrantModerateModerate

Threat of substitutesLowModerate Bargaining power of buyersLowModerate Bargaining power of suppliersModerateModerate CompetitionModerateModerate Industry attractivenessGood, especially for leading playersModerate Table 2. 0. 1Current and future industry dynamics 3. 0Company overview Tencent Holdings Limited (“Tencent” or “the company”)is a China-based internet services providing company that was founded by found in November 1998 by Ma Huateng and Zhang Zhidong, whose revenue was originally derived from advertising and premium users of QQ, and it demonstrated rapid growth

in mid of 2000’s upon the launching of fee-based QQ mobile, mobile value-added services (MVAS) and internet value-added services (IVAS) and became listed on the Hong Kong Stock Exchange on 16 June 2004 (Hong Kong Stock Code: 0700) with gross proceed of RMB1,905. 2 million[1]. Tencent aims at providing one-stop online lifestyle services to customers and thus provides users with a highly diversified product portfolio that meets the communication, information, entertainment and transaction expectations.

The year of 2006 marked the first milestone in the history of Tencent that QQ. com became the most popular web portal in China, followed by the incorporation of into the constituents of Hong Kong’s Hang Seng Index in 2008. Tencent did not satisfy with its achievements in the domestic and hence it stepped into the international internet services market by first establishing a joint venture in India in 2008. Since then, Tencent proceeded further to the international battlefield by investing in Russia, Thailand and the US subsequently (see Exhibit 3. 0. 1).

Tencent management’s dedicated commitment on research and development (R&D) enables it to leverage the growing popularity of wireless technology, for instance, the company offers IVAS such as 3G. QQ. COM, Mobile QQ, Super QQ and QQ Game etc, which were once one of the revenue contributors of the company; The development of mobile telecommunication technology provides a further development opportunity for Tencent and the company managed to offer MVAS such as QQ Box, QQ Music and QQ Reader etc, which are the current greatest revenue contributor of the company.

In 2011, Tencent launched WeChat, a offers mobile chat application that came into a great success in China and managed to expand globally with a user base exceeding 300 million in early 2013. 3. 1Product portfolio[1] Tencent’s business model is based on providing high quality free services to establish large customer base and after which offering paid services to address individual needs. It provides a comprehensive all-around-the-clock product portfolio that ties the everyday of customers with its products (see Exhibit 3. 1. 1), which could further be grouped under the following

categories: (1)Instant messaging services including QQ, QQ Enterprise, WeChat, Tencent Traveler and QQ Mail etc; (2)Online media including QQ. com (www. QQ. com) and SOSO. com (www. soso. com); (3)Wireless internet value-added services including 3G. QQ. COM, Mobile QQMusic and Mobile Game etc; (4)Interactive entertainment services including massively multi-player online games (MMOGs) such as Journey to the Fairyland, DNF and QQ Huaxia etc; (5)Internet value-added services (IVAS) including Qzone, QQMembership and QQLive etc; (6)E-commerce platforms such as PAIPAI.

com (www. paipai. com) and TENPAY; and (7)Online advertising services under the TencentMIND with clients from global brand names such as Coca-Cola, KFC and Intel etc (see Exhibit 3. 1. 2). (See Exhibit 3. 1. 3 for more details on selected Tencent’s major products) 3. 2SWOT analysis The competitive positioning of Tencent could be assessed thoroughly with the help of SWOT analysis which form the basis of the discussion on competitive advantages/ strategies in the subsequent section: Strength (S) Strong R&D commitment and capability;

Highly diversified business portfolio to lock in users, resulting in a large user base[3]; Leveraging the large user base to expand other businesses, e. g. mobile communities and games; Enhanced awareness on patent protection; Leader of several internet services in China, e. g. QQ Instant Messenger. Opportunity (O) Higher usage demand due to economic development, better telecommunication infrastructure and technological advances; Leveraging the large mobile user base to monetize its MVAS[2]. Weakness (W) Focus on new low-margin businesses (e. g. e-commerce) for growth[4];

Major business presence in China, making it vulnerable to country-specific risks and unable to benefit from the better telecommunication infrastructure on a global scale. Threat (T)[5] Increasing competition on a domestic and global scale; Failure to keep pace with fast changing technological advances leading to eroding customer base and incompatibility of products; Break-up with telecommunication operators where most revenues of MVAS are derived from; Failure of vendors to develop and maintain high-quality content for Tencent’s products/ services;

Stricter intellectual properties, privacy, e-commerce and anti-trust laws and regulations; Improper use of products by users damaging Tencent’s reputation or causing significant legal liabilities. 3. 3Competitive advantages/ strategies From the above analysis, Tencent’s competitive advantages have been built its development and innovation capabilities as well as its long-term commitment in strengthening nationwide branding in China which has been regarded as the main growth engine for most industries, especially for internet-related ones. (1)Persistent commitment on Research & Development (R&D)

With more than 50% headcount being R&D staff, Tencent has demonstrated its emphasis on its innovation capabilities. Tencent further invested more than RMB100 million in 2007 in setting up the Tencent Research Institute, PRC’s first internet research institute which focuses on the self-development of core internet technologies in pursuing its development and innovation for the industry as well as Tencent itself. The R&D capabilities not only enable Tencent to offer products that provides users with unique experience, but also meets users’ individual needs.

Further, having good patent protection may also be a critical successful factor and Tencent should also protect is R&D results in instant messaging, e-commerce, online payment services, search engine, information security, gaming through patents to preserve its competitive advantages. (2)Further expand user base and increase user engagement Industry analysts, users and even Tencent itself confirmed that the large user base due to the network effect from its complementary products under QQ’s name and the revolving lock-in effect from its paid membership (i. e. users could pay to update their avatars with new features from time to time).

Thus, more effort should be placed on enhancing user experience by providing new features, functions and compatible third party applications, while more understanding on online behavior and user preferences should also be made, with the growing the user base of Tencent Microblog and WeChat being the focus. With its success in PRC, Tencent has gone international by launching its services across Asian countries (e. g. Russia, India and Thailand etc) and the US through mergers and acquisitions, while at the same time offering English, Japanese and other versions of QQ messenger.

The continued pursuance of global presence allows Tencent to reduce country-specific risks in PRC. (3)Capture the emerging mobile internet trend [4] Tencent is the pioneer in leveraging the increasing popularity of mobile services (e. g. mobile broadband) and devices (e. g. smartphones). The ever growing utilization of mobile technology (see Exhibit 3. 3. 1 & 3. 3. 2) would provide good growth potential for Tencent’s MVAS and probably other businesses, thus Tencent should keep pace with the trend to ensure that its products and services fulfill the mobile capability requirements and expectations from existing and potential users.

3. 4Market informatics Tencent has provided a wide range of products/ services covering instant messaging, information portal, online games and e-business since establishment in 1998. By the end of 2006, QQ. com became the most popular web portal in China while its products/ services managed to secure a leading position in different segments in China, for instance: (See Exhibit 3. 4. 1-4) IM QQ: No. 1 instant messenger (up to 3/2013) Qzone:No. 1 social network service (up to 7/2011) PC online game:No. 1 PC game provider (up to 6/2012) QQ. com & 3G. QQ. COM:No.

1 Internet portal and WAP portal (up to 3/2012) With the unavailability of most up-to-date market information, this section could not affirm the prevailing leading position of above products. However, it is believed that the leading positions could be maintained with Tencent’s committed effort to enhance the quality of human life through internet services. For products in which Tencent does not enjoy a leading or dominant position, it could be observed that there is generally one dominant player in the product, for example: (a)Online search engine: Baidu Inc.

is the dominant player in this category with the 2012 market share being 79%, compared with 2% of SOSO. com (Tencent’s online searching engine) (See Exhibit 3. 4. 5); (b)C2C e-commerce portal: Taobao (Alibaba Group’s portal) is the dominant player in this category with the 2012 market share being 95%, compared with 5% of PAIPAI. com (Tencent’s portal) (See Exhibit 3. 4. 6); and (c)Online payment portal: ALIPAY (Alibaba Group’s portal) is the dominant player in this category with the 2012 market share being 47%, compared with 21% of TENPAY (Tencent’s portal) (See Exhibit 3. 4. 7). 3.

52012 operating & financial highlights 3. 5. 12012 operating highlights[6] Information on the annual average monthly actively users (MAUs) of different major products and division are given below: Product/ DivisionMAU (in million)Year-on-Year (YoY) growth rate QQ IM798. 210. 71% Qzone602. 79. 17% Pengyou247. 322. 18% Advanced Casual Games (ACG)4,300. 065. 38% Massively Multiplayer Online Games (MMOG)2,100. 031. 25% 3. 5. 22012 financial highlights[6] Total revenues were RMB43,893. 7 million, an increase of 54. 0% over the year ended 31/12/2011; Revenue from different business segments: Business segmentRevenue

(in RMB’M)YoY growth rate Internet value-added services (“IVAS”)31,995. 238. 9% Mobile & telecommunications value-added services (“MVAS”)3,723. 013. 8% online advertising3,382. 369. 8% e-Commerce transactions4,427. 8N/A: started in 2012 Profitability measures: MeasureAmount (in RMB’M)YoY growth rate Gross profit25,686. 438. 3% Operating profit15,479. 426. 3% Profit for the year12,784. 925. 0% (See Exhibit 3. 5. 1 for financial performance of Tencent in 2007-2016 and (See Exhibit 3. 5. 2) a more detailed revenue mix of Tencent) 4. 0Financial statement analysis 4. 1Corporate governance practices

The Board has established five Committees to assist the Board: Audit Committee, Corporate Governance Committee, Investment Committee, Nomination Committee and Remuneration Committee. Each of the Committees has terms of reference which clearly specifies its powers and authorities. All Committees report back to the Board and make recommendations to the Board if necessary. The terms of reference for the Audit Committee and Corporate Governance Committee can be summarized as follows: Audit Committee handles the relationship with the Company’s external auditor, PricewaterhouseCoopers; reviews the Company’s financial information;

exercises oversight of the Company’s financial reporting system and internal control procedures. Corporate Governance Committee reviews the Company’s corporate governance matters and makes recommendations to the Board; reviews and monitors the training and continuous professional development of the directors of the Company and senior management team; reviews and monitors the Company’s policies and practices on the compliance with legal and regulatory requirements; develops, reviews and monitors the code of conduct and compliance manual (if any) applicable to employees and directors;

reviews the Shareholders Communication Policy and makes recommendations to the Board where appropriate to enhance effective communications between the Company and its shareholders; reviews the Company’s compliance with the CG Code and disclosure in the Corporate Governance Report. 4. 2Tencent’s detailed financials for the year ended 31 December 2012 4. 2. 1Income statement (a)Revenues Revenues increased by 54% to RMB43. 9 billion for the year ended 31 December 2012 from the year ended 31 December 2011. Tencent has a diversified stream of revenues shown in Exhibit1-17 which consists of mainly: 1)Internet value-added services (“IVAS”);

2)Mobile value-added services (“MVAS”); 3)Online advertising services; and 4)e-Commerce transactions. In 2012, the company posted 72. 9% its revenue from IVAS; and 8. 5% from MVAS. Online advertising contributed 7. 7%, while e-commerce transactions contributed 10. 1% of its revenues. The Company’s revenue mix has evolved from instant messaging (“IM”) and MVAS-dominated to a more diverse one, coming from IM, social networking services (“SNS”), and interactive products such as QQ Pet and QQ show, casual games, massively multiplayer online role-playing games (“MMORPGs”), MVAS, and advertising.

Figure 4. 2. 1 below provides an approximate revenue contribution from various products of Tencent: Figure 4. 2. 1 – Tencent’s revenue breakdown by segment The Company mainly operates its businesses in China. Figure 4. 2. 2 below shows the geographical information on the total revenues for the year ended 31 December 2012. Figure 4. 2. 2 – Tencent’s revenue breakdown by geographic region (b)Revenue model Tencent charges usage fees from users of its products, Qzone, QQ, QQ Pet, QQ Show. Some of them are charged on item sales model, while some of them have fixed monthly payment model.

Advertising revenue mainly collected through agencies or directly from advertisers. Tencent also charges its users a fee from its Mobile value-added services, such as SMS alerts, ring tones, and wallpaper downloads. (c)Sales and marketing expenses These largely consist of advertising and promotional costs incurred for creating brand awareness towards Tencent’s various products and platforms such as online games and mobile applications. In 2012, this also included spending related to the London Olympic Games.

Sales and marketing expenses increased by 56% to RMB2,993 million for the year ended 31 December 2012 from the year ended 31 December 2011. Sales and marketing expenses amounted to 7% of total revenues for 2012, broadly stable compared to the year ended 31 December 2011. (d)General and administrative expenses General and administrative expenses largely consist of salaries and corporate overheads, and also include R&D and share-based compensation expenses. General and administrative expenses increased by 47% to RMB7,765 million for the year ended 31 December 2012 from the year ended 31 December 2011.

This was primarily driven by increases in research and development expenses, staff costs and administrative expenses, partially offset by a decrease in intangible asset amortization as certain intangible assets acquired through acquisition were fully amortised in the first quarter of 2012. As a percentage of revenues, general and administrative expenses decreased to 18% for the year ended 31 December 2012 from 19% for the year ended 31 December 2011. 4. 2. 2Statement of financial position (a)Ratios Tencent has a working capital of RMB15. 8 billion, current ratio of 1. 76 and debt ratio of 0. 44 as at 31 December 2012.

(b)Accounts receivables The receivables mainly comprise of amounts pending from telecom companies (China Mobile, China Telecommunications, and China Unicom) for WVAS segment and some advertising customers. The accounts receivable stood at RMB2. 4 billion as of the end of 2012. Figure 4. 2. 3 shows a breakdown of the accounts receivables by major customers. Figure 4. 2. 3 – Tencent’s accounts receivables by major customers Usually, telecom companies collect revenues from end-customer for its WVAS. Telecom companies transfer this amount to Tencent after collecting a fixed commission (15% in most cases).

The usual cycle for the telecom companies to clear their dues is 30 to 120 days. Advertising customers usually have a credit period of 90 days after full execution of the contracted advertisement orders. Tencent’s accounts receivable days were around 20 days. (c)Inventories Inventories are mainly merchandise purchased for the Company’s e-Commerce transactions business. As at 31 December 2012, Tencent had approximately RMB568. 1 million of inventories and its inventory turnover days was approximately 11 days. The cost of inventories was recognized as expense and included in “cost of merchandise sold” amounted to RMB4.

1 billion for the year ended 31 December 2012. 4. 2. 3Statement of cash flow (a)Operating and free cash flow Tencent has historically generated very robust operating cash flow and free cash flow from its business. Tencent has cash and cash equivalents of RMB13. 4 billion as of the end of 2012. This doesn’t include term deposits (with initial term of over three months), which were RMB10. 9 billion as of the end of 2012. The combined cash balance, including cash, cash equivalents, and term deposits over three months was close to RMB38. 1 billion. Term deposits with an initial term of over three months are denominated in US$.

Cash and cash equivalents are denominated in US$ as well as HK$. (b)Capex Capital expenditures consist of additions (excluding business combinations) to fixed assets, construction in progress, land use rights and intangible assets (excluding game and other content licenses). The company had RMB4,493. 4 million capex in 2012, representing approximately 10% of revenues. Historic capex is around 10%-15% of revenues, except for 2008 which had significant capex because of construction of a new corporate office. 4. 2. 4Others (a)Share-based compensation expenses

Tencent operates a number of share-based compensation plans (including share option scheme and share award scheme), under which the Group receives services from employees as consideration for equity instruments (including share options and awarded shares) of the Group. The directors have used the Black-Scholes Model to determine the total fair value of the options granted, which is to be expensed over the vesting period. The share-based expenses for the year ended 31 December 2012 was RMB1,012. 4 million. (b)Dividend The Board has recommended the payment of a final dividend of HK$1.

00 per share for the year ended 31 December 2012. Historic dividend payout ratio is 15-20% of net income. The Company expects payout ratio of no less than 10% of net income going forward. 4. 3Financial benchmarking To highlight potential anomalies in Tencent, Baidu and Google are selected as benchmarking companies. Baidu engages in online search and advertising businesses while Google engages in search, cloud computing, software and online advertising. It is acknowledged that these two companies do not generate major revenue from online games like Tencent does.

However, there are no other companies of comparable size and similar business that could be used for benchmarking. As such, comparison will be made with caution under this background. Financial performance for each of the 3 candidates across the latest 5 years from 2008 to 2012 would be assessed from the following perspectives: Revenue; Profitability; Short term liquidity; Long term solvency. 4. 3. 1Revenue Revenue growth rate over prior year is used to assess historical trend. All the three companies show very strong revenue growth across the past five years. However, the growth trends are different.

Google displays a relatively stable growth in recent years given it is a more mature company with much bigger revenue base. Tencent shows a decreasing rate of revenue growth. This is in line with the generic mean-reverting growth model for any relatively new companies. Baidu shows a fluctuating growth trend with its revenue growth climbing up to almost 80% in 2010 and 92% in 2011, followed by a drop to 57. 4% in 2012. The extremely high growth rate in 2010 and 2011 was due to the substantial increase in number of online marketing customers from expanded direct sales.

Besides, there was also a strong increase in average revenue per customer as a result of an increase in number of paid clicks and higher price per click. This strong growth started to decelerate in 2012. With the growing competition in existing internet services, it is likely this decreasing growth rate would continue in coming future, unless the mobile internet traffic and mobile e-commerce, another potential revenue pillar, could be increased and monetized (See Figure 4. 3. 1. 1). Figure 4. 3. 1. 1Sales growth 5-year trend Future earnings forecast for Tencent would be detailed in the next section.

4. 3. 2Profitability Operating profit margin and ROE (return on equity) are used to assess profitability. For operating profit margin, all three companies enjoy very attractive profit margin ranging from 26% to 52%. However, there was a drop in profit margin for Tencent and Google since 2011. Even Baidu started experiencing margin drop since 2012, this was largely a result of fierce competition within the internet search market and online games market (See Figure 4. 3. 2. 1). More marketing and advertising expenses are expected in future to maintain growth and strengthen industry position.

Cost of revenue is forecasted to rise too as a result of increase in traffic acquisition costs, data center costs and content acquisition costs. Figure 4. 3. 2. 1Operating margin 5-year trend Regarding ROE, all three companies suffer from a dropping ROE (See Figure 4. 3. 2. 2). This is quite consistent with the trend in operating profit margin. The same reasons mentioned above could explain the trend displayed here. Figure 4. 3. 2. 2ROE 5-year trend Although Tencent experiences a dropping ROE trend, one point worth noting is Tencent’s 2012 ROE of about 30% is still significantly above the cost of equity.

This indicates that Tencent is still able to generate sufficient money to satisfy shareholders’ required return plus future investment needs. 4. 3. 3Short term liquidity Tencent shows a slightly decreasing current ratio from 2008 to 2011 from 3. 11 to 1. 61 and stabilizes in 2012 at 1. 77 while Baidu displays a slightly improving trend from 3. 36 in 2008 to 4. 21 in 2012 (See Figure 4. 3. 3. 1). Among the three candidates, Tencent has the lowest current ratio since Tencent keeps the lowest percentage of cash and short term investments over total assets.

Tencent has utilized a higher portion of its cash to invest in various companies for future growth while Baidu has much less similar investment (See Table 4. 3. 3. 1). Google is a more mature company with market capitalization is 3. 5x of Tencent and 6. 4x of Baidu. Any investment made by Google would seldom have an impact on liquidity as great as Tencent and Baidu (See Figure 4. 3. 3. 2). Figure 4. 3. 3. 1Current ratio 5-year trend Figure 4. 3. 3. 2Total assets components 2012 Table 4. 3. 3. 1Investment in companies and acquisitions as percentage of

sales 5-year trend Although Tencent has the lowest current ratio, its short term liquidity is still satisfactory as it has 1. 77 dollar to meet every 1 dollar current liability. Unless Tencent is going to borrow aggressively in future, the short term liquidity risk is low. 4. 3. 4Long term solvency Total Debt to equity ratio and interest coverage ratio are used to assess long term solvency. All three companies show a general increasing trend in borrowings with Tencent being the first one to have borrowings back in 2009 while the other two borrowed from 2010 onwards.

This was partially to fund future acquisitions and partially to reap the benefits of relatively low interest rates in the past few years. Although Tencent had 25% debt to equity, it is only 3% higher than the industry average of 22. 15% (See Figure 4. 3. 4. 1). Given the strong growth and the number one market position in China in online games, plus the largely cash nature of business, this slightly higher debt to equity ratio is not considered to have material impact to Tencent’s long term solvency. Figure 4. 3. 4.

1 Total debt to equity 5-year trend Regarding interest coverage, calculated as operating income divided by interest expense, all three companies show very high ratios (See Table 4. 3. 4. 1). Although Tencent is still the one with lowest interest coverage, its financial strength is still robust. In fact, in Jun 2013, S&P raised its long-term corporate credit rating on Tencent to ‘A-’from ‘BBB+’ with stable outlook. This was the highest rating it had assigned to a non-state-owned enterprise in China. Table 4. 3. 4.

1 Interest coverage 5-year trend According to S&P, the improved ratings reflected Tencent’s stronger competitive position, underpinned by robust growth in business scale, an expanding user base, and improving service diversity, as well as its enhanced financial strength. 5. 0Profitability 5. 1Historical earning analysis Sales growth decreased from 87% in 2008 to 38% in 2013, while EPS growth rate decreased from 78% in 2008 to 27% in 2013. This reveals that Tencent is still at the high growth stage with mean-reverting growth rate. Table 5.

1. 1 indicates that Tencent has sound profitability in terms of GP margin, EBITDA margin, EBIT margin, net profit margin and ROE. The margin is trending down during the past 5 years mainly due to change in revenue mix and higher marketing costs, content costs, bandwidth and server custody fees as well as personnel costs. Currency: RMB000200820092010201120126m13 Sales 7,154,544 12,439,960 19,646,031 28,496,072 43,893,711 27,932,075 Sales growth87%74%58%45%54%38% EPS growth78%85%55%27%24%27% ? Overall GP margin70%69%68%65%59%55%

Operating profit margin45%48%50%43%35%34% EBITDA margin49%52%53%47%40%36% EBIT margin44%48%49%40%34%31% Net profit margin39%42%41%36%29%28% ROE40%42%37%35%30%16% Source: Tencent 2007 – 2012 annual reports and 2013 interim report *EBITDA=EBIT + depreciation and amortization **EBIT=operating profit -interest income + other loss/-other gain Table 5. 1. 1Historical earning analysis 5. 2Profitability ratios compared with industry and sector average To reiterate, Tencent is in the technology sector and internet information provider industry and Table 5. 2. 2.

1 from Reuters compares Tencent’s profitability ratios with its industry and sector averages. Apparently, Tencent’s GP margin, EBITDA margin, operating margin and net profit margin are significantly higher than its industry and sector average. ?TencentIndustrySectorTencent vs industryTencent vs sector Gross Margin (TTM)56. 2456. 0949. 330. 156. 91 Gross Margin – 5 Yr. Avg. 63. 7159. 0350. 884. 6812. 83 ? EBITD Margin (TTM)37. 02—-n/an/a EBITD – 5 Yr. Avg45. 2729. 2423. 4216. 0321. 85 ? Operating Margin (TTM)33. 8413. 7810. 7320. 0623. 11 Operating Margin – 5 Yr. Avg. 41. 8624. 6717. 4417. 1924

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