Tencent: Focus On The Core

Tencent’s super-app WeChat is the indispensable operating system of modern life in China. Tencent monetises users’ attention through a collection of digital services surrounding WeChat and its predecessor, QQ, including value-added services within its social networks; video games and entertainment; advertising; payments and financial services; and enterprise software and cloud services. Tencent also uses its surplus capital to invest in other companies, and could until recently tilt the odds in its favour by directing traffic to them.

I made the case for Tencent in early January 2022, since which the company has gone through one of its most challenging years ever. Its revenue growth rapidly decelerated from its post-COVID high of 29% year-on-year in 2Q20 to 0% in 1Q22 before contracting 3% in 2Q22 and 2% in 3Q22 – the first time in its 24-year history that revenue declined.

Looking at the charts below, it’s worth noting that growth was slowing in the first half of 2021 even before the whirlwind of new regulations launched in the second half of that year. The headwinds only got worse in 2022. The freeze on new game licences and anti-addiction measures weighed on Value Added Services (Games), while the weak economy weighed on Advertising and FinTech. I knew Tencent was flying into headwinds but I underestimated how quickly China’s economy could go from bad to worse.

Tencent’s stock trades today at HKD415, an ~8% decline since my last update and a slight outperformance compared to the MSCI AC World Index’s ~13% decline. Along the way, however, it first hit a low of HKD199 in late October 2022 after the 20th National Congress of the Chinese Communist Party when it seemed like Zero-Covid would never end, the Chinese economy was on the brink of collapse, and the Party was girding itself for external conflict.

I want to offer some thoughts here as a quick update. In sum, a lot is going right for Tencent, and the company’s earnings cycle has turned for the better. However, I am concerned about competition and growth in the domestic Games market, and sceptical about the company’s response to invest in overseas games instead.

The external environment shouldn’t get any worse

The central government ripped the Zero-Covid band-aid off at the end of last year. By most measures, the worst is over and life in the large cities has returned to normal. The central government also blinked and relaxed financial conditions, bringing much-need liquidity to the real estate sector. They have kicked the can down the road, again, but at least the risk of liquidity and solvency crises appear off the table for now.

regulatory tightening IS oveR

There were many signs confirming this in 2022, if you were looking. The Party Congress affirmed the importance of digitising the real economy to improve the quality of economic growth. Then in November, the National Press and Publication Administration (NPPA) awarded Tencent its first new game licence in eighteen months, ending the freeze which began in the summer of 2021. A few days later, the China Game Industry Group Committee declared an initial victory in reducing video game addiction among minors. Then in mid-December, the central government’s Central Economic Work Conference’s report again voiced support for ‘the platform economy’ (i.e. Big Tech).

Nonetheless, the overall regulatory regime remains tighter than two years ago. An express goal of anti-monopoly regulations was to discourage the “disorderly expansion of capital”. This sounded the death knell on Tencent’s decade-long war with Alibaba to corner new areas of the market. Less money will be burned, but Tencent will have fewer opportunities for re-investment in its home market. Arguably, its traffic becomes less valuable without this means of monetisation.

I am less worried though about the impact on engagement within Tencent’s ecosystem. First, competitors must play by the same rules. Second, the WeChat Mini-programs launched in 2017 are flourishing, with management reporting more than 600 million daily active users in 3Q22, up 30% y-o-y. The incentive for developers, merchants, and service providers to join Team Tencent of their own volition is stronger than ever.

Time spent on Short Video has stabilised

According to QuestMobile, Tencent’s ‘time market share’ fell from ~54% in 2017 to ~36% in 2021 as it ceded share to Bytedance and Kuaishou. I don’t have comparable data for 2022, unfortunately. But per QuestMobile, again, the monthly average daily time spent online in China in September 2022 increased 9% y-o-y to 7.15 hours. And at the same time, the portion of time spent on short videos (in yellow, below) stabilised in 2022 at 27.5%.

WeChat Channels short video product is succeedinG

This service was launched in early 2020 in response to the meteoric success of Douyin and Kuaishou. Much data about its progress was shared at the WeChat Open Class earlier this month, though, as usual, it was expressed in relative growth rather than absolute numbers. For example, time spent in Channels is equivalent now to 80% of the time spent in Moments (WeChat’s Newsfeed product). And this time spent is incremental to existing use, commensurate with the trends implied by Questmobile’s data.

Tencent seems, therefore, to have neutralised an existential threat. Short videos and live-streaming are also great ways to bring traffic to mini-programs, and management is confident that the short video format will support a higher ad load than the newsfeed and at a higher CPM than peers.

(Sidebar: this was notably the second consecutive year that WeChat founder Alan Zhang did not attend the WeChat Open Class. Should we expect more experimentation with WeChat’s design philosophy without his strict control?)

Prosus’s sale is to Tencent’s advantage

Another factor weighing on Tencent’s stock in 2022 was its largest shareholder’s decision to sell down its stake to buy back its own (it believes) deeply undervalued stock. Prosus and its parent, Naspers, have previously made two large sales of Tencent stock (which coincidentally marked the top in 2018 and then in 2021). However, this time Prosus made an “open-ended, multi-year” commitment to sell, seemingly regardless of price. I’ve heard the arguments for investing in Prosus, but isn’t it better to be the buyer when the other side wants to liquidate?

This is precisely what Tencent did, directing its free cash flow last year to buying back its own stock, with management reporting on the 3Q22 earnings call that their repurchases roughly equalled Prosus’ sales.

Bringing expenses under control

Like many companies, Tencent accelerated hiring and raised compensation during COVID. It also ramped up spending to promote new games and services. But when revenue growth failed to materialise, (adjusted) operating margins fell from 60% in 1Q20 to 39% in 1Q22. To their credit, management reacted quickly to the new environment by reducing headcount and cutting some 40 products. This helped earnings grow in 3Q22 even as revenue contracted. Margin improvement should continue to boost profits over the coming year, giving a fillip to the cyclical recovery in revenue growth.

no more growth for growth’s sake

Tencent’s Founder, Pony Ma, read the riot act to his senior managers at an internal meeting in December for chasing growth for growth’s sake and failing to bring many products to profitability after years of losses. His message was that Tencent’s strategy going forward will be to focus on the core (聚焦主业). Its priority will be consolidation, not expansion.

This new focus is best exemplified by the decision to slaughter a sacred cow and stop chasing revenue growth in the 'Business Services’ division. Remember, this division was created in a major restructuring in 2018 when Tencent declared that the consumer internet market was saturated and its future lay in digitising non-tech businesses (“the industrial internet”).

But by all accounts, ‘Business Solutions’ has struggled to find viable products and sales strategies in a market where competition is intense and customers do not prioritise IT spending. Going forward, instead of loss-making IaaS contracts and projects dependent on subcontractors, the division will focus instead on homebuilt PaaS and SaaS services which have been gaining traction since COVID. The best example of this is WeCom, a CRM platform businesses can use to build and manage traffic on WeChat.

Nonetheless, management has cautioned that it will still take years for these products to bear fruit because they do not know when they can start fully charging for them.

I recommend reading the news article reporting Pony’s comments in full. No one was spared.

Tencent's new direction will be a sea change from the frenetic growth of the last two decades but may be more sustainable (and hence valuable). It fits with the government’s tone and may even not matter much strategically given the strength of mini-programs. But it does beg the question, how big is Tencent’s TAM? And how much more room is there left to grow? My answers would be more conservative now than two years ago.

This leads to my final point.

Barriers to entry in Gaming ARE LOWER

Gaming is Tencent’s most lucrative means of monetising users’ attention and the most pressing concern for Pony Ma and I.

Tencent enjoys unfair advantages in the Chinese market thanks to its hard-to-obtain publishing licence; cheap traffic from WeChat and QQ; access to foreign IP; and its scale, which means it can afford to a) pay more for talent; and b) take more shots on goal. But the days where Tencent (and Netease) enjoyed a virtual monopoly are gone and a new generation of gaming companies has broken in. Some are expanding from other verticals, like Alibaba, whose ‘Romance of the Three Kingdoms: Strategy Edition” has been a breakaway hit. Others are younger prodigies, like Mihoyo, Lilith and Papergames.

In particular, Mihoyo’s open-world hit Genshin Impact stole a march on Tencent to become China’s most successful cross-platform game (i.e. playable on either mobile, PC or console) and its biggest international hit. Marrying gameplay from Nintendo’s “Zelda: Breath of the Wild” with Chinese-style live-ops, it has grossed USD4 billion in lifetime revenue since launching in September 2020, including USD164 million in December 2022 alone.

Barriers to entry are lower now that the industry has matured. The abundance of talent; cheap cloud computing paid for on a variable basis; new distribution channels like Douyin and Kuaishou; highly sophisticated third-party game engines; and the availability of finance etc. have all levelled the playing field. The genie is out of the bottle. And Tencent’s belt-tightening also creates a conservative bias, which opens the door for smaller firms willing to take more creative risks.

Tencent relies on a few mega-hits for the bulk of its Gaming revenue: Honour of Kings and Peacekeeper Elite at home; and Clash of Clans overseas. These games have strong social dynamics but are becoming long in the tooth. For example, Honour of Kings was launched in 2015 and has a reported 100 million daily active users. It earned USD268m in May 2022, up 2% y-o-y. But how much more can it grow from this size? And what are the odds that Tencent can develop another hit of similar magnitude?

Management’s response is to invest more in the international games market, but I’m sceptical. Yes, Tencent will keep first dibs on bringing international IP to China. But is it worth paying silly prices, as Tencent did, in my opinion, with Ubisoft? And what does Tencent bring to its overseas portfolio investments besides cash? I haven’t read of any synergies to date and am not convinced there will be any. The uninspiring experience of dedicated gaming roll-ups like Embracer and Stillfront bears this out.

Valuation

Tencent trades today at ~26x the mean of the sell-side’s forecast of 2023 earnings. That’s up a lot from the October low of 16x but still below the five- and ten-year average forward valuation of ~30x. The long-term averages also don’t consider Tencent’s investment portfolio, which has grown substantially in recent years. The last valuation we have for the portfolio is from the end of 3Q22, at which point it’s safe to assume the prices of Tencent’s publicly traded holdings were extremely depressed. The value then was RMB533 billion, equal at the then exchange rate to ~HKD61 per fully diluted share. Subtracting the Meituan distribution valued then at ~HKD17 per share, leaves HKD44 per share of other investments. So, excluding this conservative valuation of the investment portfolio, Tencent trades today at ~23x PE.

Wrapping it up

In sum, the external environment has improved, and Tencent’s management has done well with what’s under their control. The odds are high, in my opinion, that the earnings cycle has turned for the better.

Longer term, management argued twelve months ago that the reasons to be excited about the company are its Advertising business, Enterprise business and expansion into the international gaming market. I think Advertising will do just fine. More time spent watching short videos will create more inventory. And more engagement with mini-programs will justify spending more for that inventory. Of course, it’s also worth asking, now that lockdowns are over, what happens to that extra hour the average Chinese person spent online every day in 2022 versus 2020? And what does that mean for time market share?

However, management has effectively admitted that they were too optimistic about Enterprise and international Games has yet to be proven. The latter bears close watching because this will be where Tencent re-invests the bulk of its free cash flow in the coming years.

Disclosure: Longriver Investment Partners Limited manages the Longriver Partners Fund and separately managed accounts. These portfolios may hold or trade securities discussed in this article, and their holdings may change without notice.