Solid 2Q26 results; gradually capturing AI benefits in the long run

Solid 2Q26 results; gradually capturing AIbenefits in the long run Target PriceHK$705.00(Previous TPHK$735.00)Up/Downside52.7%Current PriceHK$461.60 Tencentannounced 2Q26 results:total revenue was up by 11%YoY toRMB204.8bn,1% ahead of Visible Alpha (VA)consensus estimate, mainlythanks to the solid growth of marketing and games businesses;non-IFRSoperatingprofitgrewby9% YoY to RMB75.6bn,1% ahead of theconsensusestimate;excluding new AI products investment,non-IFRS operating profitincreasedby19% YoY to RMB86.1bn, demonstrating resilience of Tencent’score businesses. Free cash flow also remained healthy at RMB37.6bn ifexcludingprepayments for compute procurement, though total capex was up by176% YoY toRMB52.8bn in 2Q26. We slightly lower our FY26-28E earningsforecastsby 0-1% in view of the greater-than-expected capex, and trimourSOTP-derivedtarget pricetoHK$705.0(previous: HK$735.0 based on SOTPvaluation).Despite aslowdown in short-term earnings growth(2Q26/1Q26:+9%/11% YoY), we remain upbeat that Tencent will gradually gain benefits fromAI investment in the long term through improved foundation models/productivityAI/consumer AI.MaintainBUY. China Internet Saiyi HE, CFA(852) 3916 1739hesaiyi@cmbi.com.hk Wentao LU, CFAluwentao@cmbi.com.hk Ye TAO, CFA(852) 3850 5226franktao@cmbi.com.hk Topline outperformance acrossbusiness lines.In 2Q26: 1) Gamesrevenueincreasedby11% YoY to RMB65.9bn. Domestic games revenuedelivereda solid growth of 17% YoY to RMB47.3bn, mainly driven by thestrong performance ofDelta ForceandVALORANT PC, both of whichachieved record-high DAUs in 2Q26. Overseas revenue was down by 1%YoY to RMB18.6bn, primarily due to the high revenue base ofSupercellgames.2)Marketing servicesrevenuegrewby22% YoY to RMB43.6bn,primarily driven by the AI-enhanced conversions and Video Accounts’adrevenuegrowth.Video Accounts’ total time spentrose by over20%YoYand its ad load also increased, driving rapid YoY growthof adimpressionsin 2Q26.3)Fintech and Business Services revenuewas upby9% YoY toRMB60.3bn.Cloud revenue growth accelerated to low-20%YoYthanks tothestrong AI demand and international expansion.Fintech servicesrevenue maintained healthy YoY growth. Shuyin GUO(852) 3916 3716guoshuyin@cmbi.com.hk SolidAI progress.We expect Tencent to capture value from its AIinvestment onmultiplefronts:1) foundationmodel: HY3 daily token usagegrew by 7xcompared to HY3 preview across all channels thanks to theintelligence improvement. The company plans to launch HY4 later this year,with larger parameter and enhancedmulti-modal capabilities; 2) productivityAI:WorkBuddyachievedrapid user growth and healthy user retention rates,rankingtop by monthly interactions among China’s office agents in Jun2026; 3) consumer AI: the company will continue to upgrade Xiaoweithroughenhancing core capabilities,integrating more services andstrengtheningAI infra. Investing in AI for long-term benefits.Non-IFRS OPM declined by 0.6pptYoY to 36.9%,or expanded byc.3ppt YoY to 42% in 2Q26if excludingnewAI products investment.Totalcapex grew by 176% YoY to RMB52.8bn in2Q26.Managementexpects to allocate a major part of the AI compute toitsAI-nativebusinessesfor long-term returns, rather than merelyleveragingthem for short-term revenue growth via compute rental. Source: FactSet Business forecasts updateand valuation Our SOTP-derived target price of HK$705.0comprises, per share: 1) HK$318.3for the games business, based on a22x 2026E PE, which isat a premium totheaverage PE for its global gaming peers(17x), mainly due to Tencent’s strong leadershipin China’s games industry and diversified games portfolio. 2) HK$31.1for the SNS business, including the market cap of Tencent’s stake in itssubsidiaries, the valuation of Tencent Video (based on a 3.5x 2026E PS, at a premium tothe1.2x average PS of its peers given its content and user traffic leadership), and thevaluation of other membership services (based on a 3.5x 2026E PS). 3) HK$134.9for the marketing services business, based on a20x 2026E PE, which is at apremium to the industry average (16x). This reflects Tencent’s more resilient ad revenuegrowth outlook, supported by the solid performance of Weixin Video Account and MiniProgram. 4) HK$107.5for the fintech business, based on a 4.5x 2026E PS, at a premium to the peeraverage (1.6x). This mainly reflects Tencent’s strong leadership in China’s digital paymentmarket and its potential to capture other fintech business opportunities. 5) HK$36.0for the cloud business, based on a 4.5x 2026E PS, at a discount to the industryaverage (5.7x)as Tencent’s current offerings mainly involve the lower-margin IaaSbusiness. 6) HK$72.0for strategic investments, based on the current market value of Tencent’s listedinvestments and the book value of its unlisted investments. We apply a 30% holdingcompany discount to the fair value of Tencent’s equity investments. 7) HK$5.1for net cash. Our calculation of the valuation of Tencent’sstrategic investments is ba