We affirm our Outperform recommendation on Tencent. We like Tencent’s 24,25 for total return investors given its relatively flat yield curve, and the belly part of its curve (29,30,31) for spread investors.

Tencent’s revenue growth in 1Q23 was ahead of our/market expectations thanks to a solid and broad-based recovery across its business segments, including domestic gaming, payment transactions, and online advertising. EBITDA margin was 5 ppt ahead of our expectation thanks to the recovering topline growth of its higher-margin businesses and continued cost optimization. We expect Tencent’s credit profile to improve in FY23 with continued recovery in advertising and gaming revenues, effective cost control measures, which result in improving EBITDA and free operating cash flow.

Any regulatory clampdowns abroad and domestically (e.g. antitrust rules, data security, personal information protection laws) may affect Tencent’s business. Tencent’s gaming, music streaming, and online payment units are among those that have come under regulatory scrutiny in the past. In addition, Tencent uses variable interest entities (VIEs) to circumvent China’s restrictions on foreign ownership of Internet Content Providers, which poses regulatory risks. Specifically, VIE transactions involving “change in control” will be subject to antitrust regulatory processes.

Tencent operates in a competitive market alongside other Chinese tech giants. Failure to continually innovate may result in loss of market share and profitability. Monetization of its social-network base may take time and heavy investment in payments, cloud, AI and retail businesses may weigh on margins.

The potential restructuring and spin-off of Tencent’s finance-related business into a financial holding company as ordered by the Chinese government could be a credit negative event depending on the final structural reorganization.