Morgan Stanley: Maintains "Overweight" rating on TENCENT (00700), target price HK$550, expects Q3 adjusted operating profit to decline 3.1% year-on-year.

Morgan Stanley released a research report maintaining its "Overweight" rating on TENCENT (00700), keeping the target price unchanged at HK$550, while lowering its non-IFRS operating profit forecasts for 2026 to 2027 by 1% to 2%. The bank expects Tencent's Q3 2026 revenue to grow 8.9% year-on-year, slowing from 11.0% in Q2, reflecting a weak macro environment and a higher base in the gaming business. It expects Q3 non-IFRS operating profit to decline 3.1% year-on-year, but excluding the impact of the AI business, operating profit is expected to grow 10% year-on-year. Morgan Stanley's key points are as follows: **Expects Q3 VAS revenue to grow 5.9% year-on-year, online gaming revenue to grow 7.8%** Morgan Stanley expects Tencent's Q3 value-added services (VAS) revenue to grow 5.9% year-on-year, with online gaming revenue growing 7.8% year-on-year. The bank expects domestic gaming revenue to grow 13.0% year-on-year, while international gaming revenue declines 3% year-on-year, both affected by a higher base. Social networking revenue is expected to grow 2% year-on-year. According to Sensor Tower data, Tencent continued to hold the top spot among global mobile game publishers by revenue in July and August, mainly supported by "Honor of Kings," "Delta Force," and "VALORANT Mobile." Among them, "Honor of Kings" ranked first in global mobile game revenue in Q3 2026. "Honor of Kings: ACE," launched on September 10, ranked seventh in the global mobile game revenue growth chart in September. **Expects marketing services revenue to grow 18% year-on-year, business services revenue to grow 27% year-on-year** The bank expects Tencent's Q3 marketing services revenue to grow 18.0% year-on-year, mainly driven by improved ad technology, increased ad load on Video Accounts, and search advertising business initiatives. The bank expects the marketing services business to remain resilient amid a weak macro environment and is expected to gain further growth space in the AI era. FinTech and Business Services (FBS) revenue is expected to grow 8.7% year-on-year. Among this, with strengthening market demand and improved pricing driving accelerated cloud business growth, business services revenue is expected to grow 27% year-on-year. In contrast, affected by the weak macro environment, FinTech revenue growth may slow to 4.5% year-on-year. **Expects Q3 gross profit to grow 9.7% year-on-year, AI investment weighs on short-term profitability** Morgan Stanley expects Tencent's Q3 gross profit to grow 9.7% year-on-year, with a gross margin of 56.8%, and non-IFRS operating profit to decline 3.1% year-on-year. Among this, operating profit excluding the impact of the AI business is expected to grow 10% year-on-year, with the AI business operating loss expected to be RMB 15 billion. **AI business expanding from models to platforms, Hunyuan and AI agent products continue to advance** The bank notes that Tencent's AI business progress has expanded from the model level to the platform level. The Hunyuan Hy4 Preview model was launched ahead of schedule and performed better than expected. WorkBuddy launched an open platform in September, marking its transition from a standalone office agent to an ecosystem serving hardware, applications, and developers. The bank believes that the collaborative design strategy formed by WorkBuddy together with CodeBuddy, ima, and other Tencent products is expected to benefit future iterations of the Hunyuan model. In addition, WeChat AI agent Xiaowei is expanding its testing scope to tens of millions of users, which could become an important catalyst for Tencent's AI business development. **AI investment may weigh on short-term free cash flow, funding needs expected to be met through asset sales and debt financing** Morgan Stanley believes that Tencent's front-loading of AI investment, increased capital expenditure, and higher prepayments related to computing power may pressure short-term free cash flow (FCF). The bank expects Tencent's short-term free cash flow may turn negative, but its solid core business and active asset sales are expected to support its investment needs. The bank believes any short-term funding gap will be filled through debt financing rather than equity financing. **Maintains HK$550 target price, lowers 2026 to 2027 operating profit forecasts** Morgan Stanley lowered Tencent's non-IFRS operating profit forecasts for 2026 to 2027 by 1% to 2%. It currently expects operating profit to grow 3% year-on-year in 2026, but operating profit to decline 3% year-on-year in Q3 to Q4; operating profit in 2027 is expected to be flat year-on-year. In addition, the bank raised its 2026 and 2027 capital expenditure forecasts by 3% and 12% respectively, to RMB 206 billion and RMB 224 billion. The bank maintained its HK$550 target price unchanged, derived from a sum-of-the-parts (SoTP) valuation based on discounted cash flow (DCF), corresponding to a 2027 forecast P/E of 16.4x, above the current 12.7x.