TEXT-S&P summary: Tencent Holdings Ltd.
We assess Tencent's business risk profile as "satisfactory." The company is one of China's leading Internet service providers, with 783.9 million active instant messaging user accounts as of Sept. 30, 2012. It has the largest domestic market share in instant messaging and social networking through its instant messaging tool QQ and social network platforms Qzone and Pengyou. In addition, Tencent is the largest online games operator in China by revenue, and a leading player in mobile Internet. Although China's Internet market is regulated with limited entry by major foreign companies, we believe domestic competition is intense, particularly in the gaming business, where continually launching popular new game titles remains a challenge.
We believe Tencent can maintain steady earnings over the next one to two years given the company's strong position in its major business lines. Its prime strategy is to offer diverse services to its large user base, combined with a prudent monetization strategy. In addition, the company plans to further expand its mobile Internet, e-commerce, and online advertising businesses. However, currently more than 80% of gross profit comes from the Internet business. In addition, the company's market positions in new business areas such as e-commerce and online advertising are not as strong as the core business, in our view. We believe it is strategically important for Tencent to establish a strong earnings base swiftly in the rapidly expanding mobile Internet arena.
Stable cash flows and a prudent financial policy support Tencent's "intermediate" financial risk profile. The company has maintained low leverage while pursuing growth. Its debt-to-EBITDA ratio is 1.0x as of Dec. 31, 2011. In our base-case scenario, we expect the ratio to a remain a healthy 0.5x-1.0x in the next one to two years, assuming continued strong revenue growth in 2013 and 2014 at about 20% a year and an EBITDA margin of about 40% during that period. Tencent's stable cash flows are attributable to the company's strong market position and revenue collection system. Over two-thirds of total revenue is prepaid and therefore carries no credit risk.
Tencent's investment policy is prudent, in our opinion. While the company has made several strategic mergers and acquisitions, its financial policy states that internal cash flows should fund capital expenditure. In addition, Tencent's management is committed to maintaining a net cash position given the dynamic nature of the company's business. However, in our view, severe business conditions increase impairment risk related to strategic investments.
We believe that domestic regulatory risk, including risk related to variable interest entity (VIE) structures, could affect the rating on Tencent, and any material adverse changes could negatively affect the company's corporate structure.
Tencent's liquidity is "strong," as defined in our criteria. We expect the company's sources of liquidity to exceed its uses by at least 2.5x in 2012. We also expect the ratio of liquidity sources to uses to strengthen in 2013. Our liquidity assessment is based on the following factors and assumptions:
-- Sources of liquidity include cash and cash equivalents of Chinese renminbi (RMB) 31.3 billion as of Dec. 31, 2011, and our expectation of funds from operations of RMB16 billion in fiscal 2012 and RMB18 billion in fiscal 2013.
-- We expect uses of liquidity to include capital expenditure of about RMB7 billion and short-term debt of RMB8.0 billion for fiscal 2012. We assume capital expenditure of about RMB8 billion for fiscal 2013.
-- We expect liquidity sources to exceed uses even if EBITDA declines by more than 15%.
In addition, we assume that the company will maintain a prudent merger and acquisition strategy over the next one to two years. Tencent has loose financial covenants on its borrowings.
The stable outlook reflects our expectation that Tencent will maintain steady performances in its mainstay businesses despite signs of an economic slowdown in China. We expect the company's strong market position to support its earnings. The outlook also reflects our view that Tencent will maintain its conservative financial policy and strong financial standing.
We could upgrade Tencent if we believe that the company's market position and business diversity are likely to improve further, for example by establishing a firm earnings base in the fast growing mobile Internet arena, while maintaining its No. 1 domestic market share in the profitable online game business. We believe the company could demonstrate a strong earnings base in the mobile Internet market by successfully expanding the customer base of voice messaging service Weixin to more than 400 million with a clear monetizing strategy. This level of customer base will be comparable with those of QQ and Qzone.
Conversely, we could lower the rating if Tencent cannot maintain its net cash position due to a substantial increase in strategic investments. We could also lower the rating if the company's debt-to-EBITDA ratio exceeds 2.0x and its debt-to-capital ratio deteriorates to 35% or above. This could result from a weakened market position due to tough competition, large impairment losses, or adverse regulatory changes. We could also lower the rating if a change in regulations governing VIE structures negatively affected Tencent's corporate structure or if the company were to pursue a highly aggressive debt-funded acquisition strategy.
Related Criteria And Research
-- Business Risk/Financial Risk Matrix Expanded, Sept. 18, 2012
-- Methodology And Assumptions: Liquidity Descriptors For Global Corporate Issuers, Sept. 28, 2011
-- 2008 Corporate Criteria: Analytical Methodology, April 15, 2008
-- 2008 Corporate Criteria: Ratios And Adjustments, April 15, 2008
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