Tencent Holdings (0700.HK / 700 HK) ASSUMING COVERAGE. The Penguin Empire: Rock solid

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1 Asia Pacific/China Equity Research Consumer Internet Rating OUTPERFORM* Price (18 Jul 16, HK$) Target price (HK$) (from ) ¹ Upside/downside (%) 24.3 Mkt cap (HK$ mn) 1,740,423 (US$ 224,452) Enterprise value (Rmb mn) 1,487,974 Number of shares (mn) 9, Free float (%) week price range ADTO - 6M (US$ mn) *Stock ratings are relative to the coverage universe in each analyst's or each team's respective sector. ¹Target price is for 12 months. Share price performance Price (LHS) Research Analysts Evan Zhou evan.zhou@credit-suisse.com Zoe Zhao zoe.zhao@credit-suisse.com Rebased Rel (RHS) 100 Jul-14 Nov-14 Mar-15 Jul-15 Nov-15 Mar-16 The price relative chart measures performance against the MSCI CHINA F IDX which closed at on 18/07/16 On 18/07/16 the spot exchange rate was HK$7.75/US$ Performance over 1M 3M 12M Absolute (%) Relative (%) (0700.HK / 700 HK) ASSUMING COVERAGE The Penguin Empire: Rock solid Assuming coverage with an OUTPERFORM rating and a target price of HK$230 implying 24% upside. Tencent has been an all-around platform leader in almost all sub-segments: ads, games, fin-tech and portfolio of investments. We expect solid topline delivery and a favourable mix shift to ads to drive gradual margin expansion. Value creation from the maturing star portfolio companies of Didi, CIP, Supercell, WeBank, etc., would also continue to provide catalysts to the share price in the next 2-3 years. Performance-based ad: on an open-ended runway. The key growth story of Tencent is the rise in ad contribution, especially from performance-based native ads. With the gradual opening-up of inventories on Moments, public accounts and upgrade of self-service ad systems, Tencent's performancebased ad is expected to witness a CAGR of 79% over Games, leading global franchise on PC and mobile. Tencent owns the most comprehensive portfolio of PC and mobile titles of various genres both in China and overseas. Recent mobile gaming regulations are likely to slow down releases from small studios which should benefit leading players like Tencent in gaining additional market share; Supercell's value-add to Tencent's stock would come mainly from dividend yield contribution to net profit. We expect PC/ mobile games to witness a three-year CAGR of 8% / 33% over Valuation and TP. Our TP of HK$230, implying 33.4x 2017E dil. adj. P/E, includes: (1) internet finance business' valuation of HK$24.20/sh, and (2) core business valuation of HK$205.8/sh, based on 30x 2017E P/E. We see Tencent's dominance has positioned it on a parallel footing with other global internet giants. Risks: macro and regulation headwind for ads; high base of mobile games, and faster-than-expected slowdown in key PC titles. Financial and valuation metrics Year 12/15A 12/16E 12/17E 12/18E Revenue (Rmb mn) 102, , , ,915.8 EBITDA (Rmb mn) 44, , , ,348.0 EBIT (Rmb mn) 36, , , ,853.4 Net profit (Rmb mn) 32, , , ,684.6 EPS (CS adj.) (Rmb) Change from previous EPS (%) n.a Consensus EPS (Rmb) n.a EPS growth (%) P/E (x) Dividend yield (%) EV/EBITDA (x) P/B (x) ROE (%) Net debt/equity (%) Net cash Net cash Net cash Net cash Source: Company data, Thomson Reuters, Credit Suisse estimates. DISCLOSURE APPENDIX AT THE BACK OF THIS REPORT CONTAINS IMPORTANT DISCLOSURES, ANALYST CERTIFICATIONS, LEGAL ENTITY DISCLOSURE AND THE STATUS OF NON-US ANALYSTS. US Disclosure: Credit Suisse does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the Firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. CREDIT SUISSE SECURITIES RESEARCH & ANALYTICS BEYOND INFORMATION Client-Driven Solutions, Insights, and Access

2 Focus charts and tables Figure 1: Solid WeChat MAU growth the foundation of all % 40% % % 25% % % 10% 200 5% 0 0% Figure 2: Ad revenue comparison of leading SNS players 6, , , , , , Facebook Twitter Tencent WB LINE WeChat and Weixin MAU (mn) YoY % Ad Rev (US$ mn) Ad Rev /MAU (US$) Figure 3: Mobile game ranking (by grossing) Name Jan16 Feb16 Mar16 Apr16 May16 Jun16 JX Mobile 2 Wang zhe rong yao Zhengtu 5 5 Quan min feiji da zhan CrossFire KoF Naruto Mobile Tian tian ku pao Dragonball Z mobile Re xue chuan qi Tian tian ai xiao chu Huan le dou di zhu Figure 4: China mobile payment market share in 1Q16 Lianlianpay 1.3% Lakala 1.4% Tenpay 38.3% Umpay 1.3% PinganpayOthers 1.2% 4.7% Alipay 51.8% Source: Thinkgaming Source: iresearch Figure 5: Global internet leaders comps table* Mkt cap PE Company Ticker Ccy Price Rating (US$ mn) 2016E 2017E Tencent 0700.HK HKD O 224, Baidu BIDU.US USD O 57, Alibaba BABA.US USD 82.7 O 207, Facebook FB.US USD O 341, Google GOOGL.US USD O 510, Netflix NFLX.US USD 98.8 N 42, Average Source: Company data, Bloomberg, Credit Suisse estimates. *Closing price of 18 Jul (0700.HK / 700 HK) 2

3 The Penguin Empire: Rock solid As one of the best performers in the China internet space year-to-date, Tencent has been an all-around platform winner in almost all sub-segments: ads, games, internet finance and portfolio of investments. This has been supported by (1) a clear strategy of platform positioning, (2) excellent user product design and operations, (3) forward-looking strategic investment and industry cooperation, and (4) a seasoned management to balance internal execution and market expectation. We expect solid topline delivery and a favourable mix shift to ads to drive gradual margin expansion. Value creation from maturing star portfolio companies of Didi, CIP, Supercell, JD, WUBA, WeBank, etc., would also continue to provide catalysts to the share price in the next 2-3 years. Performance-based ad: On an open-ended runway The key growth story of Tencent is the rise of advertising contribution, especially from performance-based native ads. With the gradual opening-up of advertisement inventories on Moments, public accounts and upgrades of self-service ad systems, Tencent's performance-based ads are expected to witness a CAGR of 79% over E. This growth and leverage on expenses would also translate into 44 bp/188 bp of Tencent's net margin expansion in 2017E/18E. Efforts to strike a balance between user experience and monetisation pace might often create visibility concerns on its near-term performance. Games: Leading global franchise on PC and mobile Tencent owns the most comprehensive portfolio of PC and mobile titles of various genres both in China and overseas markets. We breakdown Tencent's games segments by major game titles to analyse the robustness of the portfolio, from referencing game ranks and industry channel checks. We estimate top 5 PC titles account for 65% of total PC gaming revenue and top 5 mobile titles account for 75% of total mobile gaming revenue, which we believe is a healthy level. Recent mobile gaming regulations are likely to slow down releases from small studios which should benefit leading players like Tencent in gaining additional market share. Assuming the run-rate of Supercell's top games remains at the current level, we expect limited contribution to VAS from Tencent's potential publishing cooperation in 2017E. Supercell's value-add to Tencent's stock would come mainly from dividend income contribution to net profit. Investments: Bearing fruits for future Tencent's investment track record has been enriching its service offerings, refueling growth of its core user products, and winning good credit from investor community for management's forward-looking industry insights. Although most investors have not explicitly attributed value to many of Tencent's portfolio assets, we believe upcoming value-unlock events from key assets, especially in ecommerce, O2O and finance, would provide waves of value creation in the coming years. Inclusion of Supercell in the form of dividend payout would also add another layer of optional value for shareholders. Valuation and risks We keep P/E as our main valuation methodology, as we see Tencent's strong earnings power and cash flow are a testimony to the success of its franchise platform business model. Our TP of HK$230 implies 33.4x FY17E adj. P/E. This includes (1) internet finance business' valuation of HK$24.20/sh, and (2) core business valuation of HK$205.8/sh based on 30x FY17E P/E. We see Tencent's dominance has put it on a parallel footing with other global giants. We also performed a SOTP analysis as a reference for future value creation from its investment portfolio, especially for payment. Downside risks include: macro and regulation headwind for ads; high base of mobile games, and fasterthan-expected slowdown in key PC titles. (0700.HK / 700 HK) 3

4 0700.HK / 700 HK Price (18 Jul 16): HK$185.00, Rating:: OUTPERFORM, Target Price: HK$230.00, Analyst: Evan Zhou Target price scenario Scenario TP %Up/Dwn Assumptions Upside 40% CAGR for gross profit from 13-15E Central Case % CAGR for gross profit from 13-15E Downside 15% CAGR for gross profit from 13-15E Income statement (Rmb mn) 12/15A 12/16E 12/17E 12/18E Sales revenue 102, , , ,916 Cost of goods sold 41,631 60,360 74,020 89,625 SG&A 24,818 31,699 39,056 47,437 Other operating exp./(inc.) (7,847) (11,422) (12,856) (14,495) EBITDA 44,261 62,656 77,196 99,348 Depreciation & amortisation 7,847 11,422 12,856 14,495 EBIT 36,414 51,235 64,340 84,853 Net interest expense/(inc.) (709) (771) (1,846) (2,526) Non-operating inc./(exp.) 1,886 2,024 2,024 2,024 Associates/JV (2,793) (4,356) (4,356) (4,356) Recurring PBT 36,216 49,674 63,854 85,048 Exceptionals/extraordinaries Taxes 7,108 10,499 13,416 17,764 Profit after tax 29,108 39,175 50,438 67,284 Other after tax income Minority interests Preferred dividends Reported net profit 28,806 38,835 50,098 66,944 Analyst adjustments 3,196 5,523 6,918 7,740 Net profit (Credit Suisse) 32,002 44,358 57,015 74,685 Cash flow (Rmb mn) 12/15A 12/16E 12/17E 12/18E EBIT 36,414 51,235 64,340 84,853 Net interest (198) (1,561) (486) 194 Tax paid (7,108) (10,499) (13,416) (17,764) Working capital 14,556 (20,644) 4,680 1,845 Other cash & non-cash items 10,676 14,850 16,970 19,431 Operating cash flow 54,340 33,381 72,087 88,560 Capex (6,844) (10,378) (12,749) (15,554) Free cash flow to the firm 47,496 23,003 59,338 73,006 Disposals of fixed assets Acquisitions Divestments Associate investments Other investment/(outflows) (56,598) (17,485) (9,440) (9,440) Investing cash flow (63,442) (27,863) (22,189) (24,994) Equity raised 11,243 (2,524) Dividends paid (2.6) (2.6) (2.6) (2.6) Net borrowings 27,693 6,618 Other financing cash flow (1,375) (7,998) (5,347) (7,032) Financing cash flow 37,558 (3,907) (4,408) (6,044) Total cash flow 28,456 1,612 45,490 57,522 Adjustments Net change in cash 28,456 1,612 45,490 57,522 Balance sheet (Rmb mn) 12/15A 12/16E 12/17E 12/18E Cash & cash equivalents 81,967 83, , ,591 Current receivables 7,061 8,750 10,874 13,294 Inventories Other current assets 66,128 74,798 92, ,004 Current assets 155, , , ,889 Property, plant & equip. 9,973 13,085 18,062 24,205 Investments 105, , , ,752 Intangibles Other non-current assets 36,413 46,756 46,756 46,756 Total assets 306, , , ,602 Accounts payable 15,700 24,142 29,991 35,739 Short-term debt 11,429 12,373 12,373 12,373 Current provisions Other current liabilities 97,277 78,328 97, ,006 Current liabilities 124, , , ,118 Long-term debt 50,014 55,688 55,688 55,688 Non-current provisions Other non-current liab. 12,363 12,222 12,222 12,222 Total liabilities 186, , , ,028 Shareholders' equity 120, , , ,574 Minority interests Total liabilities & equity 306, , , ,602 Key earnings drivers 12/15A 12/16E 12/17E 12/18E Number of Premium QQ Per share data 12/15A 12/16E 12/17E 12/18E Shares (wtd avg.) (mn) 9,402 9,478 9,480 9,479 EPS (Credit Suisse) (Rmb) DPS (Rmb) BVPS (Rmb) Operating CFPS (Rmb) Key ratios and 12/15A 12/16E 12/17E 12/18E valuation Growth(%) Sales revenue EBIT Net profit EPS Margins (%) EBITDA EBIT Pre-tax profit Net profit Valuation metrics (x) P/E P/B Dividend yield (%) P/CF EV/sales EV/EBITDA EV/EBIT ROE analysis (%) ROE ROIC Asset turnover (x) Interest burden (x) Tax burden (x) Financial leverage (x) Credit ratios Net debt/equity (%) (17.1) (10.2) (30.1) (44.1) Net debt/ebitda (x) (0.46) (0.25) (0.79) (1.19) Interest cover (x) (51.4) (66.4) (34.9) (33.6) Source: Company data, Thomson Reuters, Credit Suisse estimates MF P/E multiple Source: IBES 12MF P/B multiple (0700.HK / 700 HK) 4

5 Performance-based ad: On an openended runway Figure 6: Tencent's online ad revenue growth (Rmb mn) 1Q15 2Q15 3Q15 4Q15 1Q16 2Q16E 3Q16E 4Q16E 1Q17E 2Q17E 3Q17E 4Q17E Online ad 2,724 4,073 4,938 5,733 4,701 7,453 8,969 9,941 8,230 12,300 14,085 15,364 -Video 606 1,176 1,720 1,997 1,515 2,568 3,132 3,195 2,364 4,138 4,965 5,213 -Non-Video Portal ,098 1,318 1,055 1,192 1,346 1,481 -Performance-based ad 1,300 2,057 2,386 2,916 2,532 3,970 4,738 5,428 4,811 6,970 7,774 8,670 YoY % Online ad 131% 97% 102% 118% 73% 83% 82% 73% 75% 65% 57% 55% -Video 150% 100% 150% 150% 150% 104% 92% 97% 72% 61% 59% 63% -Non-Video Portal 88% 8% -2% 13% -20% 28% 20% 10% 32% 30% 23% 12% -Performance-based ad 160% 194% 165% 165% 95% 89% 99% 86% 90% 76% 64% 60% Although China's online advertising is facing macro headwinds, Tencent's online ad business can hedge better compared with its peers, mainly due to its strong social SNS (social networking service) feature. We expect Tencent's total online ad revenue could reach Rmb31.1 bn in 2016E, up 78% YoY, mainly driven by performance-based native ad on its core mobile apps QQ, WeChat, Qzone, Tencent News, etc. We forecast performance-based ad revenue to grow 91% YoY to Rmb16.7 bn in 2016, accounting for 54% of total online ad revenue (vs. 50% in 2015). We expect this trend will continue and the revenue contribution will likely increase to 62% in Figure 7: Contribution from performance based ad to keep rising 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 39% 32% 50% 54% 56% 20% 13% 10% 62% 30% 30% 33% 33% 31% E 2017E 2018E Video Non-Video Portal Performance-based ad 7% We expect Tencent's total online ad revenue could reach Rmb31.1 bn in 2016E, up 78% YoY, mainly driven by performancebased native ad on its core mobile apps QQ, WeChat, Qzone, Tencent News, etc. (0700.HK / 700 HK) 5

6 Figure 8: Improving GPM of online ad due to increasing mix from native ad 70% 60% 50% 40% 44% 49% 50% 55% 60% 30% 20% 10% 0% E 2017E 2018E GPM % of online ad As the margin for performance-based ad is higher than overall brand ad, the increasing contribution from performance-based ad would also translate into gradual margin improvement over the next two to three years. We estimate GPM of online ad business to rise to 60% in WeChat ads: managed pace of monetisation Figure 9: Solid growth in performance-based ad revenue 60,000 50,000 40,000 30,000 20,000 10, E 2017E 2018E 200% 180% 160% 140% 120% 100% 80% 60% 40% 20% 0% As margin for performancebased ad is higher than overall brand ad, increasing contribution from performance-based ad would help improve the overall margin. Performance base ad (Rmb mn) YoY% We believe the growth in performance-based revenue mainly comes from improving advertiser inventory, fill rate/ad load, and CPC (cost per click)/ecpm improvement. So far, majority of this is contributed by Qzone advertisements currently (70-80%), as it is most advanced in monetisation which started 2.5 years ago and Qzone has 1 in six or seven feeds in 24 hours. Some of the successful marketing examples include: (1) meguo.com receiving over 100 mn daily views and 200+ effective ads, (2) Mogujie.com launched an official Qzone space, attracting 20 mn fans, and 1 mn PVs. (0700.HK / 700 HK) 6

7 Figure 10: Tencent's performance-based native ad revenue 10,000 9,000 8,000 7,000 6,000 5,000 4,000 3,000 2,000 1,000 0 Rmb mn 1Q15 2Q15 3Q15 4Q15 1Q16 2Q16E 3Q16E 4Q16E 1Q17E 2Q17E 3Q17E 4Q17E Total performance ad rev Wechat ad Qzone mobile Qzone PC In addition, Tencent has also integrated WeChat Official Account and WeChat Moment ads into the GDT (Guangdiantong, Tencent's performance-based ad platform to advertisers) engines, which would improve advertisers' experience and increase product offerings and inventory base. Tencent began to test water in launching ad in WeChat Official Account in July 2014 and Moment starting in early Figure 11: Growth of WeChat MAU Q15 2Q15 3Q15 4Q15 1Q16 2Q16E 3Q16E 4Q16E 1Q17E 2Q17E 3Q17E 4Q17E WeChat and Weixin MAU (mn) YoY % 45% 40% 35% 30% 25% 20% 15% 10% 5% 0% WeChat, launched in 2011, expanded rapidly benefiting from the traffic transfer from QQ's large user base and mobile migration. As of end-2015, WeChat MAUs (monthly active users) were 697mn, up 39% from We believe WeChat MAU will maintain decent growth in 2016 too. WeChat is one of the most successful products post QQ, and now is becoming most-often-used SNS app between friends, family and is even quite popular occupationally. (0700.HK / 700 HK) 7

8 Figure 12: CS forecast of WeChat ad revenue 1Q15 2Q15 3Q15 4Q15 1Q16 2Q16 3Q16 4Q16 1Q17 2Q17 3Q17 4Q17 WeChat MAU (Mn) ,007.4 WeChat DAU (mn) Effective Daily refresh of Moments: Ads per refresh CPC (Rmb) CTR 4.0% 4.0% 4.0% 4.0% 3.5% 3.0% 2.8% 2.5% 2.1% 2.1% 2.1% 2.1% ecpm (Rmb) Revenue per 1,000 refresh (Rmb) Net take rate 70% 70% 70% 70% 70% 70% 70% 70% 70% 70% 70% 70% Net Revenue (Rmb, mn) , , , , , , ,912.1 So far, Tencent is controlling ad loads in Moment carefully to balance with user experience. Moment has one in ten user feed, or one ad per 48 hours. In the 1Q16 earnings call, the company noted there will not be a very fast release of ad inventories going forward, considering it as a long-term business. That said, we still expect WeChat ads have large potential in the long term, and will grow from Rmb2.1 bn in 2015 to Rmb7.0 bn in 2016 and Rmb15.1 bn in Overall, we believe performance-based native ad as an open-ended runway, and as a long-term growth driver for Tencent. We expect WeChat ads to have large potential in the long term, and will grow from Rmb2.1 bn in 2015 to Rmb7.0 bn in 2016 and Rmb15.1 bn in Figure 13: WeChat Moment ad sample Figure 14: Qzone mobile performance-based ad sample Source: Company data Source: Company data (0700.HK / 700 HK) 8

9 Peer comparisons Figure 15: Global comparison of SNS players 6, , ,000 3,000 2, , Facebook Twitter Tencent WB LINE - Ad Rev (US$ mn) Ad Rev /MAU (US$) Source: Company data, revenue and MAU based on 4Q15 numbers, Credit Suisse estimates Ad revenue of Tencent is still small compared with global leading players such as Facebook. In 4Q15, Tencent's ad revenue was US$882 mn, only one-sixth of Facebook's ad revenue of US$5.6 bn. In addition, we use quarterly advertising revenue/ MAU ratio to measure the monetisation level of those peers. The monetisation rate for domestic SNS players is still low, with US$0.55 for WB and US$0.59 for Tencent, while it's US$2.83, US$2.00 and US$0.41 for Facebook, Twitter and LINE. We believe there's still great room for further monetisation upside for Tencent. Figure 16: Comparison of leading domestic performance-based ad players 7,000 6,000 Rmb mn The monetisation rate for domestic SNS players is still low compared with global leading players. We believe there's still great room for further monetisation upside for Tencent. 5,000 4,000 3,000 2,000 1,000 0 Toutiao WeChat Weibo NTES news Sohu news Both SNS players and news apps are the main platforms for in-feed ads. Toutiao (Today's Headline, 今日头条 ) is one of the most popular news apps in China. It was launched in 2012, and its MAU crossed 125 mn recently. According to ZOL news, Toutiao's ad revenue was about Rmb3 bn in 2015 and it targets revenue of Rmb6 bn in 2016 (up 100% YoY+). In addition, we expect WeChat and Weibo's ad revenue to also grow rapidly due to popularity of the in-feeds ad formats. (0700.HK / 700 HK) 9

10 Games: Leading global franchise on PC and mobile Figure 17: Online game revenue breakdown (Rmb mn) 1Q15 2Q15 3Q15 4Q15 1Q16 2Q16E 3Q16E 4Q16E 1Q17E 2Q17E 3Q17E 4Q17E Online game revenue 13,313 12,970 14,333 15,971 17,085 16,948 17,628 18,107 18,895 19,082 19,813 20,416 -QQ Game Platform Advanced Casual Games 7,789 7,439 7,762 8,123 8,478 8,215 8,445 8,675 8,829 8,979 9,285 9,577 -MMOG Games 2,707 2,672 3,009 3,180 3,364 2,985 3,146 3,149 3,248 3,142 3,272 3,269 -Mobile Game 2,644 2,708 3,181 4,253 4,924 5,023 5,336 5,602 6,157 6,319 6,635 6,967 YoY % Online game revenue 28% 17% 27% 33% 28% 31% 23% 13% 11% 13% 12% 13% -QQ Game Platform -52% -27% 161% 269% 83% 156% 16% -3% -11% -11% -11% -11% -Advanced Casual Games 25% 15% 10% 16% 9% 12% 11% 10% 8% 9% 10% 10% -MMOG Games -1% 1% 13% 24% 24% 13% 7% 1% 0% 5% 4% 4% -Mobile Game 151% 55% 114% 86% 86% 86% 68% 31% 25% 26% 24% 24% We see a solid outlook for Tencent's online gaming business. We expect Tencent's online gaming revenue to reach Rmb69.8 bn in 2016, up 23%. Mobile game is still the growth driver and we forecast it to grow 63% to Rmb20.9 bn in Figure 18: Revenue contribution of key game titles diversification through mobile portfolio 60,000 50,000 Rmb mn Mobile game revenue ramps up since 2014 We expect online game revenue to reach Rmb70 bn in 2016, up 23%, driven by mobile game growth. 40,000 30,000 20,000 10, League of Legends Dungeon & Fighter Cross Fire Blade & Soul T-Game Call Of Duty OL Other PC Wang zhe rong yao Zhengtu Naruto Mobile Quan min fei ji da zhan Re xue chuan qi CrossFire Dragonball Z mobile KoF 98 Tian tian ku pao Tian tian ai xiao chu Other mobile Before 2014, majority of online gaming revenues came from PC games. The key PC titles included League of Legends, Dungeon & Fighter, Cross Fire, T-Game, etc. We estimate top 5 PC titles contribute 65% of total PC revenue. Mobile gaming revenue began to ramp up in "Quan min fei ji da zhan" was among the first batch of mobile games operating on WeChat. Then Tencent launched the "Tiantian series" including "Tiantian ku pao", "Tian tian ai xiao chu" and other casual games. With improving technology for mobile games and increasing penetration of largescreen smartphones, mid & hard-core games (mainly MMORGP genre) are becoming more popular and are now the main contributor of Tencent's mobile gaming revenue. (0700.HK / 700 HK) 10

11 According to our estimates, the top 5 mobile titles account for 75% of total mobile game revenue in Figure 19: Blended margin trend for online games 68% 66% 67% 64% 62% 63% 60% 58% 56% 59% 58% 57% 54% 52% E 2017E 2018E GPM % of online game We estimate the overall GPM for online games will gradually trend down mainly due to the increasing revenue mix from mobile games. So far, the sector GPM for PC games is over 70% while GPM for mobile games is lower at around 50%. Solid growth of mobile gaming portfolio Figure 20: Growth of total mobile game revenue 60,000 50,000 40,000 30,000 20,000 10, E 2017E 2018E 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% We estimate the overall GPM for online games will gradually trend down mainly due to the increasing revenue mix from mobile games. Mobile game revenue (Rmb mn) YoY % Mobile games have been growing rapidly during the past two years, since their ramp up in With the increasing large base and fewer big PC titles untapped, we expect the growth of mobile games will gradually cool down in the next few years, likely to ~16% in In 2Q16, as of end of Apr/ May/ Jun, Tencent had 10/11/12 titles in the Top 30 in terms of grossing. Tencent is still the player with most titles, followed by NetEase with four. In addition, Tencent has five titles in Top 10. (0700.HK / 700 HK) 11

12 Figure 21: Grossing ranking of Tencent's mobile games Tencent accounts for 40-50% of top 30 Name 中文名称 Nov-15 Dec-15 Jan-16 Feb-16 Mar-16 Apr-16 May-16 Jun-16 JX Mobile 剑侠情缘 2 Wang zhe rong yao 王者荣耀 Zhengtu 征途 5 5 Quan min fei ji da zhan 全民飞机 CrossFire 穿越火线 KoF 98 拳皇 Naruto Mobile 火影忍者 Tian tian ku pao 天天酷跑 Dragonball Z mobile 龙珠激斗 Re xue chuan qi 热血传奇 Tian tian ai xiao chu 天天爱消除 Huan le dou di zhu 欢乐斗地主 Source: Thinkgaming According to iresearch, Tencent accounted for over 40% of the mobile gaming market share in Its strong distribution capabilities also help attract cooperation with more successful CPs. The mid and hard core games from successful PC IPs will continue to be the promising titles, including Zhengtu (Giant Interactive), Classic TLBB (Changyou), JX Mobile (Kingsoft/Westhouse) and others. Expect market share expansion from more stringent regulation On 30 June 2016, Apple announced that approval from the State Administration of Press, Publication, Radio, Film and Television of The People's Republic of China (SARFT) is a must for mobile games to publish on ios platform. SARFT issued a notice on 24 May to strengthen the regulation on mobile game distribution. The regulation states that all mobile games need to be reviewed and approved by SARFT. We believe the new regulation likely puts more pressure on small CPs or individual developers of mobile games. As the application process is complicated, it is likely to drive out smaller players in the mobile gaming market. We believe there will be little impact on big players, due to their greater resources. Therefore, we expect big players like Tencent to benefit from the likely consolidation as they grab more share. PC games: Core base stays resilient We believe the new regulation likely puts more pressure on small CPs, while big players like Tencent to benefit from the likely consolidation. Figure 22: Revenue growth of PC games 60,000 50,000 40,000 30,000 20,000 10,000 16% 14% 12% 10% 8% 6% 4% 2% E 2017E 2018E PC game revenue (Rmb mn) YoY % 0% We expect Tencent will likely invest in more foreign gaming studios to make up for its relatively weak in-house game development team, while NetEase and Perfect World will (0700.HK / 700 HK) 12

13 still remain focused on in-house developed games. According to 17173, Tencent has eight titles in the Top 30 PC games, among which only two titles are in-house developed games. We forecast PC game revenue to reach Rmb48.9 bn in 2016, up 12% YoY. Figure 23: Tencent's key PC titles stand stable in Top 3 (by power times) Aug-15 Sep-15 Oct-15 Nov-15 Dec-15 Jan-16 Feb-16 Mar-16 Apr-16 May-16 Jun League of Legends (T) Cross Fire (T) Dungeon & Fighter (T) T-Game (T) Dota2 (P) Hearth Stone (N) Call Of Duty OL (T) Overwatch (N) Moonlight blade (T) Warcraft (N) Source: Shunwang, "T" short for "Tencent", "N" for "NetEase" and "P" for "Perfect World" According to Shunwang, Tencent's titles League of Legends, Cross Fire and Dungeon & Fighter, have been stable in the Top 3 PC game rankings over the past year. Overall, 7 of the Top 10 titles are from Tencent, in terms of power times. In addition, Blizzard's new FPS title Overwatch (launched on 24 May 2016), made a strong debut on the ranking board. We believe it will have large impact on Crossfire (#1 FPS game in China), as Crossfire users have high loyalty. It appears that LoL may be more directly affected but it's still too early to determine the sustainability of Overwatch. Even if the traffic for LoL is impacted by Overwatch, the monetisation impact may lag. Tencent's titles League of Legends, Cross Fire and Dungeon & Fighter, have been stable in the Top 3 PC game rankings over the past year. Figure 24: Ranking of PC games Rank Title 游戏名称 Developer Operator 1 League of Legends 英雄联盟 Riot Games Tencent 2 Dungeon & Fighter 地下城与勇士 Neople Tencent 3 Overwatch 守望先锋 Blizzard NetEase 4 Fantasy Westward Journey 2 梦幻西游 2 NetEase NetEase 5 Cross Fire 穿越火线 Smilegate Tencent 6 Hearthstone 炉石传说 Blizzard NetEase 7 World of Warcraft 魔兽世界 Blizzard NetEase 8 JX 3 剑网 3 Kingsoft Kingsoft 9 TLBB 新天龙八部 Changyou Changyou 10 Moonlight Blade 天涯明月刀 Tencent Tencent Source: Company data, 17173, Note:* Ranking date on 4-Jul-2016 In 17173's PC game ranking (measured by a weighted index, including playing users, playing time, searching index, etc.), Tencent has 4 titles in the top 10, namely LoL, Dungeon & Fighter, Cross Fire and Moonlight Blade. In addition, Tencent has 8 out of Top 30. (0700.HK / 700 HK) 13

14 Global expansion through M&As In June 2016, Tencent announced it would buy up to an 84.3% stake in leading mobile game developer Supercell for ~US$8.6 bn from SoftBank and other previous shareholders, together with potential co-investors. The deal values Supercell at US$10.2 bn. Supercell is one of the most successful game developers globally with games such as Clash Royale, Clash of Clans, Boom Beach and Hay Day. It generated revenue of US$2.3 bn with a profit of US$964 mn in FY2015. With the launch of Clash Royal in 2016, both revenue and profit should be growing decently in 2016E, likely 30%+ YoY if we estimate. Figure 25: Revenue rank in mobile games by company, ios + Android Rank By Revenue Headquarters Game Apps 1 Supercell Finland 8 2 Tencent China Activision Blizzard US Machine Zone US 6 5 NetEase China Mixi Japan 47 7 BANDAI NAMCO Japan Netmarble Korea LINE Japan SQUARE ENIX Japan 325 Source: App Annie, May 2016 We are positive for the following reasons: (1) adding the global leader Supercell with over 100 mn DAU to seal Tencent s dominance, (2) not consolidate or equity-account gives clarity to existing financial disclosure and enables independence of Supercell s operation, (3) cooperation to launch Tencent's version of Supercell s products in China soon; and (4) future outside co-investment to alleviate cash use burden. We believe the deal could help alleviate investor concerns on the recent slowdown in activities of LoL, due to the launch of Overwatch (Blizzard). Tencent should remain the leader of online gaming market, both in China and overseas, especially in mobile games. Before Supercell, Tencent had already had a long list of overseas investment in game companies, like in the US, Korea and Japan, in order to secure its gaming pipeline, especially on mobile. Tencent also owns shares in global big gaming companies. For example, Tencent acquired 100% shares of Riot Game (developer of League of Legend) in Tencent also owns 6% of Blizzard's (developer of Warcraft) shares. Figure 26: The world of Tencent Gaming investments We believe the Supercell deal could help alleviate investor concerns on LoL, due to launch of Overwatch. Tencent should remain the leader of online gaming market, both in China and overseas, especially in mobile games. Source: Company data (0700.HK / 700 HK) 14

15 Figure 27: Tencent's investment in gaming companies Year Company Country Amount % of shares 2006 GoPets Korea Rmb32.8 mn 17% 2007 Yonghang China n.a 63.90% 2007 Vina Games Korea n.a 30.20% 2008 Outspark US US$11 mn n.a 2010 Wangyu China Rmb456 mn 100% 2010 GH Hope Island Korea W2.5 bn n.a 2010 Eyedentity Korea W4 bn n.a 2010 Redduck Korea W1.5 bn n.a 2010 Nextplay Korea W1.5 bn n.a 2010 Topping Korea W1.5 bn n.a 2010 Reloaded Studios Korea W5.5 bn n.a 2010 Studio Hon Korea W1.45 bn n.a 2011 Riot US Rmb1.68 bn 100% 2011 Manyougu China Rmb764 mn 62.50% 2011 Epic Games US Rmb2.09 bn 48.40% 2011 Kingsoft network China Rmb742 mn 15.30% 2011 Yinhan China n.a 15% 2012 Level Up Singapore Rmb348 mn 100% 2013 Blizzard US US$1.4 bn 6% 2013 idreamsky China US$15 mn 20.40% 2013 Plain Vanilla Iceland co-invest US$22 mn n.a :33 Creative Lab Korea co-invest US$110 mn n.a 2014 Playdots US co-invest US$10mn n.a 2014 Aiming Japan n.a 16.84% 2014 Artillery US n.a n.a 2014 CJ Games Korea US$500 mn 28% 2014 Qingtianzhu China Rmb150 mn n.a 2014 TapZen US US$8 mn n.a 2014 PATI Games Korea W20 bn n.a 2014 Yidongyule China Over Rmb10 mn n.a 2015 Glu Mobile US US$126 mn 14.60% 2015 Miniclip Switzerland n.a largest shareholder 2015 Hammer&Chisel US n.a n.a 2015 Pocket Gems US US$60 mn 20% 2016 Paradox Interactive Sweden Rmb138 mn 5% 2016 Supercell Finland US$8.6 bn 84.30% Source: com (0700.HK / 700 HK) 15

16 Investments: Bearing fruits for future Tencent's investment track record has been enriching its service offerings, refuelling growth of its core user products, and winning credit from investor community for management's forward looking industry insights. Although most investors have not explicitly attributed value to many of Tencent's portfolio assets, we believe upcoming value-unlock events from key assets, especially in ecommerce, O2O and finance, would provide waves of value creation in the coming years, which would gradually prompt the investor community to value it on an SOTP basis. Inclusion of Supercell in the form of a dividend payout would also add another layer of optional value for shareholders. Tencent's investment track record has been enriching its service offerings, refuelling growth of its core user products, and winning credit from investor community for management's forward looking industry insights. Figure 28: Tencent's ecosystem E-Commerce O2O OTA Finance Social network Media More categories JD Youxin Maima Meike Missfr Huak Koud Wanda e- commerc BitAuto Renrench CIP Didi ele.me 1jiajie 58.co Lyft U-Xian MJBan Leju Guaha Dingxiang Huitong Nanjing elong LY.com woqu.co WeBank Futu ZhongAn Insurance Renrendai Yixin Capital China Postal Bank Wechat QQ/QQ Zone Tencent Weibo Zhihu Kakao Talk Kiki Same Snapchat Whisper AltspaceVR WhoSay PPYX Heirloom Penguin Pictures Tencent Pictures Tencent Video China Reading Tencent Games Tencent Comic QQ Music Tencent Games Weiying Technology Dian FM Guagua.cn Bona / Huayi RRKD China South City Mascotte HDS Sinopec Scaled Inference Sanadu Tile Picooc Kingsoft Naviinfo Sogou Magic WiFi Huan Source: Company data, Credit Suisse research Tencent is most proactive in exploring and investing in start-ups among BAT. It mainly focuses on minority investments. O2O remains the hottest category in Tencent's investment initiatives. Major landmark transactions include joint investments in Didi Kuaidi, Meituan Dianping and 58.com. Tencent continues to adopt a strategic investment approach by forming firm cooperation with invested companies, instead of taking a controlling stake. This mild approach also allows Tencent to expand its investment coverage faster without paying excessive premium in an acquisition transaction. (0700.HK / 700 HK) 16

17 Figure 29: Tencent total equity investment (US$Mn) 8,025 Figure 30: Tencent investment transactions by category Investment amount (US$Mn) 6,000 5,000 O2O 5,522 4,000 3,000 1,187 1, ,000 1,000 - Healthcare Auto ecommerce Social network Media Game Number of transactions Source: Company data, Credit Suisse research Source: Company data, Credit Suisse research O2O services Tencent focuses on high-frequency O2O services, including investment in Didi Kuaidi and Dianping, etc. Significant offline exposure is needed, which is not the core strength. Tencent likely leverages its capital on a more efficient basis. Didi Kuaidi Didi Kuaidi was merged by two leading taxi hailing companies, Didi and Kuaidi, in February Since its inception, the competitive landscape of taxi market in China has changed dramatically. By leveraging the mobile internet, DidiKuaidi has bridged offline taxi hailing needs with online information to form an O2O closed loop. It innovatively improves the user experience in taxi hailing, and enables taxi drivers to pick up passengers based on current location and target destination, which reduces the communication cost between drivers and passengers, and improves the utilisation rate of the taxi. According to iresearch, Didi Kuaidi's market share in 2015 reached 88.4%. Meituan Dianping According Analysys, Meituan food delivery had around 33% market share. The merged Meituan-Dianping, now named China Internet Plus (CIP), announced a record-breaking US$3.3 bn financing on 20 January 2016, according to NetEase News. Tencent actively invested at least US$1 bn in the latest round which boosts the new company's valuation to US$18 bn. Meanwhile, Meituan-Dianping confirmed to continue its focus on food delivery services one of its key product categories after movie-ticket and group-buy providing financial support on fulfilment improvement and category expansion in the next 1-2 years. Tencent focuses on highfrequency O2O services, including investment in Didi Kuaidi and Dianping, etc. Significant offline exposure is needed, which is not the core strength. (0700.HK / 700 HK) 17

18 Internet finance Besides the O2O segment, internet finance is also one of the key focuses of Tencent. We believe Tencent's internet finance business will contribute more meaningfully in 2017 with payment and loan-related services. In our valuation for Tencent, we include the value of internet finance-related businesses (Tenpay+WeChat payment, financial product distribution, and micro loan valuation) at US$29.3 bn (or HK$24.2/sh). While the largest value comes from payment, Tencent is making great efforts in non-payment financial businesses, such as Licaitiong (its online wealth management product distribution) and the small-micro lending business conducted by WeBank. We believe the financial business will result in greater upside to its valuation. Strong mobile payment progress The number of mobile payment users exceeded 400 mn in This significant increase was mainly driven C2C transactions (such as red envelope and money transfer), offline payment promotions, games, and O2O payments. We believe Tencent's internet finance business will contribute more meaningfully in 2017 with payment and loan-related services. Figure 31: Mobile payment market share in China (1Q16) Figure 32: Total online payment market share in 2015 Lianlianpay 1.3% Lakala 1.4% Tenpay 38.3% Umpay 1.3% PinganpayOthers 1.2% 4.7% Alipay 51.8% Alipay 58% Tenpay 20% ChinaPnR 2% China UnionPay Online 6% 99Bill 4% Others 10% Source: iresearch Source: iresearch, Credit Suisse estimates According to iresearch, Tenpay was the second-largest player in the mobile payment market, with 38% market share in 1Q16. As for the total online payment market (including PC and mobile), Tenpay took ~20% of the market share in Due to its lack of a strong e-commerce business historically, Tenpay's business has mainly focused on Tencent's various entertainment-related services (games, red packets, etc.), and newly acquired O2O services, such as taxi-hailing, restaurants, among others. Tencent's aggressive Red Packet campaign during the Spring Festival contributed a lot to the rapid growth of Tenpay and WeChat payment platforms. We expect Tenpay to be able to leverage WeChat's large user base and active user engagement to enable more innovative application scenarios. WeChat Payment uses Tenpay for its back-end payment infrastructure. It has launched various personal financial services, such as AA payment, lottery, mobile phone recharges, utility fee payment, movie ticketing, O2O services, among others. According to Tencent, its mobile payment application has more than 400mn users. In future, Tenpay may launch more new functions through WeChat. The main source of balance in the WeChat Wallet is Red Packet and Money transfer. Tencent disclosed that 516mn WeChat users participated in a total of 32.1bn Red Packets (0700.HK / 700 HK) 18

19 between 7 and 12 February 2016, Chinese Lunar New Year, compared with 3.27 bn during the same period last year. Figure 33: WeChat wallet features cellphone bill payment Licaitong: Tencent's internet finance platform Uitilities payment services: water, electricity, broadband, and etc City services: such as tax services and gov services Wechat red packet Third party services: Didi Chuxing, Train tickets, Meilishuo, JD, Movie tickets, Dianping Source: Company data, Credit Suisse research In addition, Tenpay has been aggressive on promoting its payments in offline malls or retailers. Tencent has established partnerships with supermarkets, such as Carrefour, Wumei and Yonghui, to grab offline market share. We believe the promotion campaign will continue in 2016 and the competition will intensify. So far, WeChat payment is available with over 300,000 offline retailers and we believe this number will continue to grow rapidly given Tencent's aggressive promotion. According to a survey conducted by Penguin Intelligence, simple process, convenience and discounts are the main factors that affect users' choice for WeChat payment. There are over 500mn transactions daily through WeChat payment. Valuation of Tencent's internet finance businesses For Tencent, we value its internet finance-related business at US$29.3 bn, including payment infrastructure revenue of US$23.5 bn, the financial product distribution business at US$1.1 bn, and WeBank's small and micro loan business at US$4.7 bn. Figure 34: Valuation of Tencent internet finance-related business (Tenpay + WeChat payment, financial product distribution, and micro loans) Rmb bn 2018E Tenpay Amount Economics Rev Net NI P/E Valuation Valuation Valuation market size % (2018) Margin (Rmb bn) (US$ bn) (HK$ per share) Payment infrastructure 21, % 5, % % Financial product distribution % % Small & micro loans (WeBank) % % Total valuation Payment value of US$23.5 bn We assume Tencent, via Wechat mobile payment and Tenpay, to account for about 25% of the total online payment market share in the long term. We see this as a relatively We value its internet finance-related business at US$29.3 bn, including payment infrastructure revenue of US$23.5 bn, the financial product distribution business at US$1.1 bn, and WeBank's small and micro loan business at US$4.7 bn. (0700.HK / 700 HK) 19

20 conservative estimate of market share for Tencent, considering its recent progress in offline payment. We project the total online payment market to grow to US$21.8 bn in Tenpay occupied 20% market share in With it further leveraging its large user base, we expect its market share to grow to 25%. Financial product distribution We conservatively assume Tencent to distribute wealth management products worth Rmb397 bn by By assuming Tencent could take a distribution fee of 0.25%, total revenue from these products would be Rmb0.5 bn. We believe this number could have further upside opportunities, as it is only 2% of total bank wealth management product market size. Small and micro loan WeBank, founded in late 2014, is the first private internet bank in China. Tencent owns a 30% stake in WeBank. WeBank s scope covers personal banking, corporate banking and international banking. Its first product 'Weilidai', provides personal credit lines to users without the need for guarantee or collateral, on a limited scale. New challenges that mobile internet faces today: As a result of the rapid development of mobile internet, internet finance companies are feeling increased pressure to deal with the massive amount of customer request simultaneously and to serve a diversified customer base with complex requirements and low loyalty. The traditional financial services cannot provide the user experience that meets the customers' needs. Focus on customer experience, big data analytics and highly effective, low cost solutions: To solve the challenges, internet finance companies should aim for (1) best-inclass user experience that includes personalised, smart, forward-looking and active services; (2) big data capabilities to study and understand customers' past behaviour, financial record and social data; and (3) highly effective, low cost solution to support simultaneous requests, 24-hour service, complex requests and to deal with multi-end, multi-system environment. Weilidai ( 微粒贷, "Micro Loan") effectively improved user experience, lowered cost and improved revenue: The credit line product was specially designed to optimise customer experience with an effective risk control system, based on multi-dimensional user data. The solid model enables continuously decreasing marginal cost and contribution to revenue. WeBank is expected to make profit from next year. Innovative internet finance product to customers, great outlook ahead: WeBank targets mass individuals between 25 and 35 years of age with an average loan size around Rmb10,000 and an average repayment period of five months. Customers can apply for such micro loans for setting up small businesses or for consumption. WeBank aims to promote personal credit lines to more users in China and expand the market size, as it believes there is a huge potential population to penetrate, and providing best products and services will be the key competiveness. As the lending business is still at an early stage, we apply a US$4.7 bn valuation to this business, using 20x P/E on the back of Rmb1.5 bn profit it could generate in 2018E. We assume WeBank would see loan balances grow from Rmb7.5 bn at end-2015 to Rmb43.7 bn by mid We expect Tencent, as a referrer of borrowers to WeBank, could be able to generate a net fee of around 3.5% of outstanding loan amount in (0700.HK / 700 HK) 20

21 Valuation and risks We maintain our OUTPERFORM rating with a TP of HK$230 (from HK$190) We arrive at our target price using the following methodology: (1) Main valuation methodology: P/E Our main valuation methodology is forward P/E, as we see Tencent's strong earnings power and cash flow are a testimony to the success of its franchise platform business model. Our TP of HK$230, implies 33.4x FY17E dil. adj. P/E. This includes (1) internet finance business valuation of HK$24.2/sh, and (2) core business valuation of HK$205.8/sh, based on 30x FY17E, parallel with other global internet giants. Figure 35: Global internet leaders comps table* Mkt cap Company Ticker Ccy Price Rating (US$ mn) 2016E 2017E Tencent 0700.HK HKD O 224, Baidu BIDU.US USD O 57, Alibaba BABA.US USD 82.7 O 207, Facebook FB.US USD O 341, Google GOOGL.US USD O 510, Netflix NFLX.US USD 98.8 N 42, Average Source: Company data, Bloomberg, Credit Suisse estimates. *Closing price of 18 Jul PE Our TP of HK$230, implies 33.4x FY17E dil. adj. P/E. This includes (1) internet finance business valuation of HK$24.2/sh, and (2) core business valuation of HK$205.8/sh, based on 30x FY17E. (2) Sum-of-the-parts (SOTP) We also use SOTP to gauge Tencent's valuation. We arrive at an SOTP value of HK$228/sh. We estimate Tencent investment has a current market value of US$21 bn, including JD.com, 58.com, Meituan Dianping, and other investments. Figure 36: Tencent SOTP valuation Business lines Revenue (Rmb Mn) Earnings Multiple Value (Rmb Mn) Value (Rmb mn) Value (US$ bn) Value (HK$) Low High Low High Mid-point Per share Community VAS 21,450 7,507 25x 35x 187, , , PC game 52,126 23,457 12x 17x 281, , , Mobile game 43,465 15,213 25x 35x 380, , , Brand & video ad 21,754 3,916 20x 30x 78, ,473 97, Performance-based ad 28,225 9,879 35x 40x 345, , , Tenpay & WeChat Payment -2, , , , Net cash 31,298 31,298 31, Market value of investments 141, , , Total Value 1,636,488 2,069,526 1,853, Price per diluted share (Rmb) Price per diluted share (HK$) (0700.HK / 700 HK) 21