Tencent: Smarter Marketing Dollars

What’s New -Q1 revenues were RMB22.4bn, up 22%y/y and 7%q/q, slightly aboveconsensus. Adjusted EBITDA was up 47%y/y with EBITDA margins rose8ppt. Margin improvement was mainly from 29% decrease in selling and marketing expenses. Tencent said it had reduced the promotional expensesassociated with its taxi apps. Non-GAAP profits were RMB7.1bn and EPS of RMB0.75/share,+35%y/y. The Firm recorded RMB9.7bn in Q1 operating cash flows and net cash at quarter end was RMB25.3bn. The number of actives users on WeChat/Weixin accelerated in the month, up 49m q/q to 549m, this compares with 32m q/q increase in Q4 2014.

Social Network and Gaming -Q1 VAS revenues were up 29%y/y driven by 28% increase in online gaming revenues and 32% increase in social network revenues. PC gaming revenues benefited from increased in-game transactions from League of Legends and FIFA Online 3. Gross mobile game revenues was RMB4.4bn, up 82%y/y and 8% sequentially. While the year on year growth was strong, the sequential lift was slightly disappointing for mobile game gains.

Advertising & Other -Online ad revenues rose 132%y/y to RMB2.7bn driven by strength in video advertising and performance based social advertising on mobile QQ and Weixin. Tencent said 40% of its brand display and 75% of its performance based ad revenues were generated from mobile platforms in the quarter.Tencent reported other revenues of RMB1.1bn, up 266% mainly due to increase online payments business and the inclusion of e-commerce.

Forecasts and Valuation -We are increasing our 2015 EPS estimate from RMB3.32 to RMB3.40 and our FY2016 EPS from RMB4.64 to RMB4.90. Our FY2017 EPS estimate is RMB6.36. Our 12-month target price is raised from HK$159/share to HK$184/share based on 30X our FY2016 earnings estimate of HK$6.12/share. Our target price implies 0.8X PEG on 2015-17E earnings growth of 37%.

Recommendation & Outlook -Both revenues and earnings were better than our estimates. Going forward, what investors need to get a excited about is the operating leverage. Tencent cut marketing expenses by 29% without hurting revenues near term,while growing its mobile user base materially. The firm is arguably getting better at targeting its users in pursuit of monetisationof its user base. The outlook remains fairly positive with a number of mobile monetisation efforts really just starting to kick in,including advertising through Weixin Moments and the start of thefirm's online banking services. We maintain our BUY recommendation for the stock.

Risks: (1) Decline in PC gaming revenues due to competition and or substitution from mobile. (2) Disruptive technologies reducing the attractiveness of Tencent’ssocial networks. (3) Inability to monetise WeChat/Weixin mobile platform. (4) Security and regulatory risks around internet banking and online payments.