Credit Update: Tencent records a quarter of negative free cash flow as AI capex surges

We previously initiated coverage and provided an update on Tencent’s bonds earlier this year:

Idea of the Week: Capturing China’s AI boom via Tencent bonds  

Credit Update: Tencent - The AI Cash Engine

Tencent recently announced its 2QFY26 earnings (ending 30 June 2026). In this article below, we delve into the group’s latest numbers and provide an updated take on the credit standing of the technology giant.

1. Durable revenue base meets expanding earnings

• For 2QFY26, Tencent demonstrated continued expansion in its core earnings base. Group revenue rose 11% YoY to RMB 204.8b (compared to 2QFY25: RMB 184.5b), representing an acceleration from 1QFY26’s 9% pace. Gross profit ticked up 13% YoY to RMB 118.4b. That said, EBITDA growth of +8% YoY to RMB 85.8b notably lagged both revenue and gross profit growth, with EBITDA margins softening slightly to 42% (2QFY25: 43%). This slight downtick in EBITDA margin reflects an increase in research and development expenses (+35% YoY to RMB 27.2b), alongside increased sales and marketing (+26% YoY to RMB 11.9b) to fund the group’s AI product build-out. We note that even amid its elevated investment cycle, Tencent’s EBITDA margins remain solid at 40+%, a level that comfortably supports debt service, and the widening gross profit pool provides further cushion.

• Marketing services continued its 1QFY2026 operating trajectory; revenue surged 22% YoY to RMB 43.6b (1QFY2026: +20%), driven by an upgraded AI ad recommendation model and expanded closed-loop marketing within Weixin. AIM+, Tencent’s automated campaign management solution, was upgraded with end-to-end execution capabilities (smart product solution, creative generation, dynamic bidding) for mini shop and mini drama advertisers, deepening advertiser stickiness. Video accounts' advertising impressions grew rapidly, with management noting that Tencent’s advertising load remains below industry levels, implying further monetisation headroom. Advertising spending continued to broaden across major industries (eCommerce, internet services, local services), reducing concentration risk. For bondholders, this is exactly the kind of recurring, high-margin, low-capital-intensity cash generation that supports Tencent’s debt-servicing capacity.

• FinTech and Business Services saw revenue up 9% YoY to RMB 60.3b, with cloud revenue growth accelerating to the “low-20% range”, driven by AI-related demand across GPU rental, Model-as-a-Service, WorkBuddy/CodeBuddy, and continued international expansion. Importantly, management reaffirmed that Tencent AI Cloud continues to generate positive gross margins despite low domestic token prices, and flagged that Tencent remains compute-constrained, indicating demand is running ahead of available supply. We view cloud as an increasingly important source of revenue diversification; that said, we do not expect full monetisation and subsequent flow-through to earnings in the near term.

• Value-Added Services (VAS) saw revenue growth of +8% YoY to RMB 98.4b – a meaningful rebound from 1QFY2026’s spring-festival-affected +4% YoY growth, validating our prior view that 1Q’s softness was a timing artefact. Domestic games were the standout at +17% YoY to RMB 47.3b, with Delta Force and VALORANT PC (evergreen titles that enjoy sustained retention and recurring monetisation) hitting lifetime-high daily active users (DAUs). International games grew YoY on a constant currency basis (-1% reported) as gains in Wuthering Waves and VALORANT PC were offset by softer Supercell contributions. Social networks performance was near flat at +0.8% YoY to RMB 32.5b as declining long-form video subscriptions were offset by rising audio subscriptions. Notably, video accounts' total time spent grew over 20% YoY – engagement that monetises primarily through advertising and Mini Shops rather than Social Networks itself, meaning the segment’s soft headline understates the underlying strength of Tencent’s broader content ecosystem.

• Looking ahead, management remains constructive across all three segments: Marketing services should sustain double-digit growth as AI advertisement efficiency and video accounts monetisation scale, Cloud is expected to accelerate further (especially should compute constraints ease) and gaming is well-supported by an expanding evergreen portfolio and international portfolio. That said, while we remain positive on the technology giant’s ability to grow its topline, we do not expect an immediate substantial contribution from AI monetisation to its EBITDA margin as the group continues to invest heavily in AI. In our view, EBITDA margins could moderate moving forward, but we do not expect any material worsening that would impair Tencent’s debt-servicing capability.

2. Adequate Liquidity with little refinancing risk

• Compared to 1QFY2026, Tencent’s available liquidity has softened, but remains decent. As of 30 June 2026, the group’s total liquidity profile stood at RMB 421.2b, of which RMB 206.9b is held in cash, and the other RMB 214.3b is in term deposits maturing over the next twelve months. Against a gross debt figure of RMB 453.0b (RMB 54.6b comes due within the next twelve months), Tencent slipped into a net debt position (Note: this is our conservative estimate compared to the group’s reported figure as non-current deposits, among others, are excluded) of RMB 31.8b, against a net cash position of RMB 36.5b (1QFY2026). We highlight that since 1QFY2026, Tencent’s borrowings increased by 15% QoQ to RMB 298.9b on the back of its June 2026 issuance of ~RMB 31.7b to fund its AI investments. Even with this swing to net debt, we remain comfortable with Tencent’s liquidity position and do not see any immediate refinancing stress given its robust cash on hand of RMB 206.9b against RMB 54.6b of current borrowings due within the next twelve months.

• Operating cash generation declined 29% YoY to RMB 52.7b (2QFY2025: RMB 74.0b). Tencent attributes the softer operating cash generation to its compute prepayment (RMB 51.4b); operating cash flow (OCF) would have been RMB 104.1b (+41% YoY) instead, excluding this prepayment. Capital expenditure (capex) surged 115% YoY to RMB 66.5b (2QFY2025: RMB 31.4b), as Tencent significantly increased its AI-related investments. Consequently, free cash flow (FCF) for the quarter slipped to negative RMB (13.8)b. On balance, this is an undoubtedly softer quarter in cash generation compared to 2Q2025; that said, we do not view this as an indication that Tencent’s ability to generate solid cash flows is structurally impaired but more reflective of a group in a capex-investment phase.

• Looking ahead, management expects to spend heavily on AI-related investments for 2HFY2026, which could cause OCF and FCF to remain pressured (compared to the recent past) for a while before we see a substantial improvement in cash generation as AI monetisation picks up steam. Lastly, we highlight that management is open to the idea of channeling funds earmarked for share repurchases (RMB 14.7b for 2QFY2026) to fund compute requirements, if the economics of the latter are more beneficial for the group. We read this as mildly supportive for Tencent’s credit profile as it indicates there is flexibility in allocating less capital towards share repurchases.

3. Softer credit profile due to AI investment needs, but interest coverage remains ample

• Given Tencent’s issuance of ~RMB 31.7b of debt in June 2026 and swing to a net debt position, leverage picked up for the group: gross debt / TTM EBITDA is now at 1.4x (1.2x as of 1QFY2026) and net debt / TTM EBITDA stands at 0.1x. Even so, we remain highly comfortable with Tencent’s balance sheet, and in our view, leverage remains low.

• On interest coverage (TTM EBITDA / TTM net interest expense), we find a QoQ improvement from 22.5x (end-Mar’26) to the current 24.6x as net interest expense was flat while EBITDA picked up slightly. We continue to think that this strong interest coverage ratio provides meaningful headroom for Tencent’s debt-paying capacity. In sum, while leverage and coverage might further soften as the group increases its AI-related investments, we do not expect a material worsening in Tencent’s credit profile.

Recommendations

• Overall, we think Tencent’s credit has softened since our 1QFY2026 update, though we remain comfortable with the issuer’s credit standing. Topline growth accelerated, with core profitability (EBITDA) still increasing, but trailing revenue growth as the group increased its spending to support its AI rollout. With debt issuance and increased capex, Tencent slipped into a net debt position, and cash flows moderated as well. That said, interest coverage is ample and leverage metrics remain muted. As highlighted previously (see articles above), the scenario we hypothesised (capex spending might pick up due to AI) has come to fruition, moderating both OCF and FCF. While OCF and FCF might remain subdued going forward, we do not expect any material / structural deterioration in the group’s ability to generate cash. Therefore, we remain comfortable with Tencent’s softened, but still decent credit profile.

• Looking at Table 1 below, TENCNT 3.595% 19Jan2028 Corp (USD) trades at a yield to worst of 4.34% with 1.4 years to maturity, while TENCNT 5.000% 16Jun2036 Corp (USD) offers a yield to worst of 5.17% with 9.8 years to maturity. Relative to comparable US Treasuries, these issues offer a fair yield spread of 20+bps and 50+ bps, respectively. Compared with close technology peers, we find these issues fairly priced.

• For investors seeking exposure to AI-related bonds, we think SK Hynix’s 6.375% 17Jan2028 Corp (USD) and META’s 4.875% 15Nov2035 Corp (USD) offer more attractive yields (see Table 1 below); the former for short-term income and the latter for more medium-to-long-term income. You can find our most recent pieces for SK Hynix and META here: 

Idea of the Week: AI-memory boom fortifies SK Hynix’s 4.66% short-term USD bonds

Credit Update: META’s capex ramp accelerates, cash flow compresses 

Table 1: Peer Comparison:

Declaration: For specific disclosure, at the time of publication of this report, IFPL (via its connected and associated entities) holds a position in META 4.600% 15May2028 Corp (USD) and the analyst who produced this report hold NIL positions in the abovementioned securities. This research report was prepared with the assistance of artificial intelligence (AI) tools. iFAST Financial Pte Ltd does not rely exclusively on AI for content generation; the content of this report – including all investment theses, ratings, price targets and conclusions – has been independently reviewed and verified by the research analyst(s) to ensure accuracy and professional integrity.