Amid Regulatory Crackdown in China, Tencent Is a Buy

We think Tencent TCEHY is a safer play among China Internet firms given its known restraint in monetization of data, more proactive social response initiatives, more compliant culture and strong fundamentals. We continue to think it is a buy. We maintain our forecasts and fair value estimates.

Management said that as it is not nearly as aggressive as its western peers or certain local peers in granularity and specificity of ad targeting relative to the user data that it has access to, it doesn’t appear to think the data regulation will have a large impact on its advertising business. Investors have criticized Tencent in the past for the limited data sharing between Weixin and other business units previously, but we think this could play in the company’s favor in the current environment. Management expects quite a few regulations to come; regulation overhang will remain until at least early next year, in our view.

Amid strong regulatory pressure, we appreciated management dedicating a session of its call discussing how Tencent helps society, such as reducing barriers for technology adoption and charging very low or even zero payment take rates for small and midsize enterprises. Despite Tencent’s increased social response initiatives, we think Tencent will keep its non-IFRS margin profile relatively stable in the long run and for revenue growth from SME to slow. As loss-making business and contribution back to the society wane on profit margin, we think management can pick up its pace in monetization of more mature businesses to offset the effect--video accounts are an example.

For the second quarter of 2021, Tencent's total revenue was CNY 138.3 billion, up 20% year on year. Tencent’s operating profit before interest income and other gains, net, was up 3.9% year over year with margin down by 340 basis points. This is due to lower gross margin as a result of lower contributions from higher-margin privileged subscriptions and PC games, higher bandwidth, and server costs for the advertisement business. Higher investment in business services, short videos and games businesses also played a role, offset by a favorable mix shift in the fintech and business services segment.

International games revenue grew 29% year on year, or 37% in constant currency terms, accounting for 26% of games revenue. We like a few international games with strong IP that Tencent’s studios are working on, which are likely to help drive international gaming revenue, a key growth area that is supported by the Chinese government. We think these pipelines give Tencent diversification from domestic regulatory risks. We like Supercell’s development of three new games based on its well-known Clash IP. The turn-based strategy game Clash Quest is now under beta testing in Scandinavia. Riot is developing a mobile version of Valorant, which is a PC game that attracted 14 million monthly active users in the first year. Alchemy Stars was the most downloaded tactical RPG in Japan in July, a very early sign that Tencent may be able to penetrate another established international game market. Management mentioned extending its presence in emerging game genres, one example is Undawn, an open word survival crafting game, which has accumulated more than 30 million pre-registrations in China. As a reference, the popular PUBG mobile game, which has become Peacekeeper Elite, had 50 million pre-registrations. During the quarter, under 16-year-olds accounted for 2.6% of its China game grossing receipts, and under 12-year-olds accounted for 0.3%. Management disclosed that cracking down on minors using adult accounts, for example those purchased on third-party platforms to skirt Tencent’s gaming protection system, would lead to a mild revenue impact over the 0.3% or 2.6%. We think significant gaming revenue comes from adults who have high earning power and the gaming revenue coming from minors is unlikely to be material.

Weixin Mini Programs GMV grew more than double year on year as decentralization from major e-commerce platforms has been a trend benefiting Tencent, and ad revenue in Mini Programs doubled year on year as a result. More advertisers have adopted Mini Programs as the landing page. Video accounts growth will also drive ad loads and CPMs eventually, but is not a focus at the moment. These collectively will continue to drive social advertising revenue in the long term, in our view. Nevertheless, a plunge in after-school tuition advertisers, the regulations of launch screen, and macro weakness will put pressure on advertising in the near term.

Tencent gave some insights on opening its ecosystem with another platform and it implies to us that opening its ecosystem to Alibaba BABA is not a priority for Tencent. There are concerns of differences in rules and commercial policies between platforms, and how to deal with piracy and counterfeits.

Morningstar Premium Members gain exclusive access to our full analyst reports, including fair value estimates, bull and bear breakdowns, and risk analyses. Not a Premium Member? Get this and other reports immediately when you try Morningstar Premium free for 14 days.