Tencent Stock: Cloud Growth Could Generate Value (OTCMKTS: TCEHY)

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There is a chance that Tencent Cloud could achieve profitability in terms of positively adjusted EBITDA in the next year or two.

Tencent (OTCPK: TCEHY) has invested a lot of capital in developing Tencent Cloud and the business has been growing very quickly in the last few quarters. As a result, it has realized more scale that could potentially allow it to gain higher margins.

There might be reason to believe Tencent Cloud could be profitable within a few years because Alibaba Cloud, the current leader in China’s cloud sector, became profitable in terms of positively adjusted EBITDA for the December quarter of 2020 with cloud revenue of $ 2.47 billion. Although Alibaba Cloud was only slightly positive in terms of adjusted EBITDA margin for the quarter, it was nevertheless a big achievement for the company as it showed that the cloud business was closer to being self-sustaining than before.

Given its growth rate, Tencent Cloud could achieve the same scale to potentially realize positive adjusted EBITDA margins either in 2022 or 2023.

According to Canalys for Q2 2021, the cloud infrastructure services market in China grew 54% year over year to $ 6.6 billion. Tencent Cloud had 18.8% market share and grew 92% year over year. Given its market share, Tencent Cloud had cloud infrastructure services revenues of $ 1.24 billion for the quarter.

Assuming that Tencent Cloud maintains the 92% growth momentum from Q2 2021, Tencent Cloud could potentially achieve cloud infrastructure services sales of around $ 2.46 billion for Q2 2022. That’s around the same revenue as when Alibaba first achieved profitability for its cloud business.

Given it’s hard for a company with billion dollar revenues to grow 92% year over year, however, Tencent Cloud’s growth might not be as strong as before and the business could take longer to achieve profitability.

Indeed, Tencent Cloud’s growth slowed in the following quarter. According to Canalys for Q3 2021, the cloud infrastructure services market in China grew 43% year over year to $ 7.2 billion. In the quarter, Tencent Cloud had 16.6% market share and also 49.5% growth.

Assuming 49.5% year over year growth, Tencent Cloud might not achieve quarterly revenues of $ 2.47 billion until late 2022 or 2023.

While it might take a little longer to realize more scale, Tencent Cloud is nevertheless very likely to grow to a point where it achieves positive adjusted EBITDA margins in the future given the business’ growth momentum and how fast the Chinese cloud market is growing.

Tencent Cloud could also benefit from Alibaba Cloud’s slowdown. Due to company specific headwinds, Alibaba Cloud growth slowed from 33% for the September 2021 quarter to 20% for the December 2021 quarter. If the Chinese cloud market grew faster than 20% for the December 2021 quarter, Alibaba Cloud very likely lost market share. With a less dominant cloud leader in China, Tencent Cloud could potentially find it easier to gain market share as well.

Potential for a Higher Valuation

Given that the market isn’t giving Tencent much credit for its potential with all the headwinds and the 45% stock price decline from February 12, 2021, I estimate the market is probably valuing Tencent Cloud around $ 100 billion based on its present market share, growth rate, and potential.

If Tencent Cloud becomes profitable, however, Tencent could potentially put it into its own business segment rather than as part of the FinTech and Business Services business. With its own business segment, Tencent Cloud could potentially gain a higher valuation and Tencent could gain a higher valuation as well.

Furthermore, Tencent would also have the option of eventually spinning off its cloud business that could potentially add more value. For Tencent, a spin-off is likely easier if the cloud business is profitable than if it isn’t.

In the long run, there is potential for more upside for Tencent Cloud.

Given that the Chinese cloud sector is still developing, the Chinese cloud market is expected to grow substantially in the future. According to China Cloud Computing Development White Paper in 2021, China’s cloud sector could grow from RMB0.2 trillion yuan in 2020 to RMB1 trillion in 2025.

Given that the cloud market in China could increase by a factor of 5 from 2020 to 2025, I think there’s potential for Tencent Cloud to be worth at least $ 200 billion and likely more by 2025.

Assuming a 20% market share and a China cloud market size of RMB1 trillion in 2025, Tencent Cloud could have annual revenues of $ 31.66 billion in 2025. Assuming a price to sales valuation of 10, Tencent Cloud could be worth $ 316.6 billion.

In 2025, Tencent Cloud could potentially have even more revenue given the growth opportunities in Southeast Asia and the SAAS cloud market in China as well.

If Tencent Cloud fails to maintain its current growth momentum, however, there is also the possibility that it might not have as much market share as 20% in the future. The market may also value Tencent Cloud at a lower price to sales valuation. If that’s the case, Tencent Cloud could be worth less and Tencent as a whole might not have as much upside.

Gaining Market Share Rather Than Optimizing for Profits

There is also a chance that Tencent Cloud does not achieve profitability in terms of positively adjusted EBITDA in the next two years despite reaching the same scale as when Alibaba Cloud achieved profitability.

Given that the Chinese government doesn’t want its big companies to grow too much currently, it could be that Tencent management decides to postpone the time Tencent Cloud becomes profitable until perhaps a more favorable regulatory environment.

Given its other businesses, Tencent is already very profitable and the company doesn’t necessarily need its cloud business to be profitable anytime soon.

One way Tencent management could do this would be running the cloud business to gain as much market share as possible rather than optimizing for profits.

Tencent management could potentially achieve those goals through more investments or more marketing to gain market share but also potentially lowering adjusted EBITDA margins.

Tencent Stock Likely Higher in Several Years

Due to the macroeconomic and government headwinds that Tencent and other Chinese tech giants face, I am currently neutral on Tencent stock. Nevertheless, given the stock decline of 45%, Tencent Cloud’s potential, and the potential of Tencent’s other businesses, I think Tencent’s stock price will likely be higher in several years.

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