Is Tencent Past the Worst as Government Sends Easing Signals?

Key Takeaways:

• Tencent reported its first quarter profit fell 22.9%, but the market believes the worst is past after Beijing’s recent end to its freeze on new game approvals
• The company believes a recent wave of government regulation could soon ease, but time will be needed for that to translate to higher revenues

By Fai Pui

A recent article headlined “No one cares about the economy except Hu Xijin” went viral on the internet. It touched on how the former editor in chief of the nationalistic Global Times was vigorously championing the cause of Chinese private companies in the context of the pandemic, calling them “the bottom line of the Chinese economy that should not be allowed to drop.”

That story took on another wrinkle last week as Tencent Holdings Ltd. (0700.HK) Chairman Pony Ma, famous as one of China’s most bashful tech billionaires, shared the article, including his own highlight of one section that read: “For some people on the internet, the way to show that they care about the Chinese economy is to insist that companies can go bankrupt but cannot lay off staff and ask them to work overtime. They don’t understand nor care how the Chinese economy really works. For them, the Chinese economy equals microchips and the so-called hardcore technologies.”

The article and Ma’s reposting have prompted heated discussion as investors in China’s most valuable tech firm looked for signs about Tencent’s future. Ma’s remarks reflect the dilemma China’s big tech companies now face as they are told to rein in their activities, while also maintaining their role as major employers. The company’s stock has held up relatively well so far, even as many China internet stocks tanked, and even after it released unflattering financials last week and news abounds of significant company layoffs.

Still considered a high-growth company despite its massive size, at least up until now, Tencent reported 135.5 billion yuan ($20.3 billion) in revenue for the first quarter, up a scant 0.12% year-on-year, representing its slowest growth in the 18 years since it went public. Its non-IFRS net profit plummeted 22.9% to 25.55 billion yuan, marking the third consecutive quarter of declines. Its shares fell 6.5% to HK$340.20 ($43.34) the next day, reflecting investor disappointment.

Zero gaming growth

Tencent’s core online gaming business saw zero growth in the first quarter after a series of regulatory crackdowns over the past year, marking its worst performance since 2019. The company admitted that the central government’s policy to limit online gaming by teens had dealt a blow to its number of active and paying users, both directly and indirectly. But things are picking up as the government appears to be promoting development of the “platform economy” again and has resumed approvals of new games after an eight-month freeze.

“Tencent might not have received any game approvals in the latest round, but will definitely in the near future since the government has sent an important signal to the market that the gaming business will be better regulated, but not to the extent that renders the industry virtually non-existent,” said Dickie Wong, executive director of research at Kingston Securities. 

According to data from market research firm Sensor Tower, Tencent’s mobile game “Honor of Kings” brought in $274 million in April, up 6.2% year-on-year, making it the most profitable mobile game in the world. The No. 2 is also a Tencent game – “PUBG Mobile” with revenue of $218 million for the month. Wong argues Tencent’s ability to continue posting growth shows its games are still very popular despite continued government efforts to curb gaming addiction among teens. He further predicted government policies will be generally supportive of the gaming industry.

Chinese internet companies have been on edge for over a year now. A cascade of antitrust moves has sent most of the biggest names scrambling to change their strategies, including Tencent. Its Tencent Music TME subsidiary was a target of antitrust actions, ordered last year to halt its practice of signing master licensing agreements for all of China with major music labels.

But Tencent should count itself lucky that authorities have yet to launch any antitrust action against its biggest prize: the WeChat messaging app that has become a ubiquitous tool for everything from sharing photos to paying bills. The app connects all of Tencent’s products on a single platform, and its user base grew by 3.8% in the first quarter to a staggering 1.29 billion. Microapps within its ecosystem now have more than 500 million daily active users.

The sheer scale of its user base – almost equal to the entire population of China – worries the company about its vulnerability to accusations of abusing its market power. But Kingston Securities’ Wong is convinced that recent statements from Beijing, especially from Premier Li Keqiang in support of the platform economy, mean the government may soon relax the regulatory straightjacket it has imposed on the internet, which will help to ease investor concerns.

Tencent President Martin Lau said in last week’s analysts’ meeting after release of the results that it would take a while for the positive government signals to become concrete actions. That means such actions might only materialize after the government feels its industry overhaul is complete, meaning benefits would not appear in the company’s financials until much later.

Tencent might be able to expect a regulatory respite in the not-too-distant future. But even so, more daunting challenges will come in the form of tough competition and a sluggish overall Chinese economy. Its first-quarter advertising revenue dropped by 17.6% to 18 billion yuan as industries like fast-consumer goods, e-commerce and tourism were hit by pandemic controls and the broader economic downturn, resulting in dramatically lower ad spending.

Target price downgrades

Macro factors aside, Tencent has found a formidable threat in Douyin, the wildly popular Chinese version of TikTok. The popularity of short videos as a form of advertising has put Douyin in prime position to trawl for ad traffic, and the TikTok international version is growing exponentially outside China. Even Facebook founder Mark Zuckerberg has conceded that his company has lost plenty of users to TikTok. TikTok’s higher ratio of returns on costs for content production is also putting pressure on Tencent.

Major investment banks responded to Tencent’s latest quarterly report by downgrading their target prices for the company. Citibank believes improvement in its domestic gaming revenue and gaming approvals will more than offset the impact on its payment and advertising businesses from the Shanghai Covid lockdown. Accordingly, it maintained its “buy” rating on the company, but revised its target price down from HK$522 to HK$512.

JPMorgan has maintained its “overweight” rating as well, convinced that the pandemic’s impact on the company will subside by June and its weak performance will start to bottom out in the second quarter. But it also reduced its target price from HK$470 to HK$440.

Who would have guessed that Tencent, a stock market heavyweight that spent heavily on M&A, would ever need to pare back expenses with layoffs? But that’s exactly what is happening now. Tencent Sports cut a third of its employees in mid-May, and its cloud and smart industry division let go of 15% of its staff in March. Two of its affiliated gaming livestreaming platforms, Huya HUYA and Douyu DOYU also went through some similar reshuffling in April. That shows the company is trying to tighten its belt to make it through the difficult period.

China’s internet slowdown is beyond dispute. The camera-shy Pony Ma’s sudden sharing of a controversial article understandably made some investors a tad uneasy about the company’s prospects. But luckily, the government seems ready to ease its recent flood of regulation. Only time will tell how far that easing goes, which will be critical to determining whether the company can regain its appeal to investors.