Tencent Holdings (Part 3): The Future of Tencent

In Part 1 of our Tencent series, we introduced the history and components of the Tencent Holdings ecosystem, while in Part 2 we conducted a financial analysis of the company.

In this final installment of our Tencent series, we explore Tencent's future, including management's strategy for each business segment, important macro trends, and key regulatory factors affecting the company going forward.

Tencent Holdings Series

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Overview of Future Strategies

According to Tencent's most recent earnings call in March 2022, management plans to invest in three strategic growth areas going forward: software-as-a-service (SaaS), video accounts, and international games. We discuss each of these areas in the context of their respective business segments in the sections below.

From a broader perspective, management also emphasizes optimizing costs, increasing efficiency, focusing deeper on key strategic areas, and adopting more sustainable long term growth strategies in response to the changing regulatory environment.

Value-Added Services (VAS)

We first look at Tencent's value-added services (VAS) segment, comprising of: (1) domestic games, (2) international games, (3) communication and social, and (4) digital content.

We discuss each sub-segment in turn below.

Domestic Games

While domestic games account for nearly a quarter of Tencent's total revenue (see Part 2), growth prospects for the business segment going forward are somewhat uncertain and subject to a degree of regulatory risk. In spite of the seemingly harsh measures implemented by the Chinese government to restrict game play by minors (i.e. those under 18) and control youth gaming addiction, management states that direct revenue impact was insignificant due to the already small contribution of game spending by this age group. However, the new regulations did have an indirect impact on revenue as a result of resource reallocation where the company had to reallocate certain development resources away from new games and content development to focus on implementing (practical) minor protection measures. Tencent believes the company will finish internalizing the impact of last year's minor protection measures in the second half of 2022.

Note: for perspective, Tencent started implementing measures to comply with the Chinese government's new regulations on game time restrictions for minors on September 1st, 2021. During the month, users under 18 years old accounted for 0.7% of the total time spent on Tencent's domestic gaming platforms and contributed to 1.1% of domestic gaming revenue, in comparison to 6.4% of total time spent and 4.8% of revenues from domestic games during September the previous year. In Q4 2021, minors accounted for 0.9% of the total time spent on Tencent's domestic gaming platforms and contributed 1.5% towards domestic gaming revenue.

Going forward, it is uncertain whether or not there will be regulations to curb gaming addiction in adults. If the Chinese government were to launch such regulations, we think the measures implemented will be more mild than those that were launched to target youth addiction, although the direct impact on Tencent's revenues would be far more substantial due to the higher purchasing power involved. We emphasize that even without such drastic regime changes, the domestic gaming industry in China will always be subject to greater regulatory risk than its off-shore counterpart due to the existing approval system where electronic games are required to have a license (called "banhao", Chinese: 版号) before they can be monetized. Specifically, gaming companies and distributors can release free trials of games, but cannot monetize them without a banhao.

Note: the Chinese regulators suspended the issuance of banhaos from July 2021 until late April 2022, resulting in a build-up of unmonetized games in Tencent's inventory over the past year. The regulators had also previously suspended banhao issuances from March 2018 to April 2019 due to no publicly apparent reason. In general, there has been no clear trend or warning indicators as to when banhao issuances will be temporarily suspended, highlighting a certain regulatory risk with regards to China's domestic gaming business.

International Games

Management intends to focus on growing Tencent's international games business as one of the company's three strategic growth drivers. Games released abroad are not subject to the banhao approval requirement, while the international games segment itself has shown rapid growth with a year-on-year increase in revenue of 31% in 2021, compared with 6% for domestic games the same year. Tencent also plans to increase its pace in acquiring promising gaming studios in order to expand the company's international and domestic gaming businesses, which is likely to benefit the former more than the latter in the short to medium term as new games can be freely released and monetized without hindrance in offshore markets.

Note: historically, Tencent's success in the gaming business derived from both developing games in-house and by acquiring third-party game developers

Communication and Social

Tencent plans on expanding its video accounts functionality on the Weixin application (see Part 1) as a key growth driver for the company. The video accounts functionality was launched in 2020 to facilitate the sharing and livestreaming of video content in response to the popularity of social media platforms such as Douyin (the domestic mainland China version of TikTok) and Kuaishou. While Tencent is still in the early stages of monetization for video accounts, management plans on boosting revenue from tipping and increasing livestream e-commerce gross merchandise value (see Part 1), in addition to promoting short video feed advertisements (i.e. advertisements embedded in users' short video feeds) which are predicted to be the largest revenue opportunity derived from the video accounts functionality. The time spent on video accounts and the total videos viewed by each daily active user more than doubled from Q4 2020 to Q4 2021, although raw numbers are not disclosed.

Digital Content

Tencent's digital content segment faced multiple headwinds in 2021 with tighter regulatory scrutiny resulting in content launch delays (entertainment programs are also subject to an approval process before they can be broadcasted or streamed) and last year's anti-trust crackdown reducing the company's market share*. Given the significant reliance of Tencent's digital content segment on intellectual property and content acquisition, we don't think the company will be able to grow at the rates it once did with market monopoly rules in place going forward. Of course, a more fair and competitive business environment should benefit China's economic growth and development in the long run.

*See our summary here of how Tencent was fined by the regulators and asked to remove exclusive copyright licenses held by the Tencent Music platform

Refer here for a summary of the internet platform anti-trust guideline regulations issued at the end of 2020.

In 2021, Tencent's total number of VAS subscriptions grew nearly 8% year-on-year in spite of the tightening regulatory environment during the second half of the year. The growth in subscriptions included a 1% increase in subscriptions on Tencent Video and a 36% increase in subscriptions on Tencent Music, offset by decreases in subscriptions across Tencent's other media platforms (see Part 1). Management does not mention specific future plans for the digital content segment, although the company has been implementing a cost optimization process to reduce Tencent Video's financial losses while maintaining the platform's prominent market position.

Online Advertising

Next, we turn to Tencent's online advertising segment, comprising of the social and other advertising and media advertising sub-segments.

During the latter half of 2021, Tencent's online advertising business faced a series of regulatory changes that had direct and indirect impacts on various advertiser industries and on the online advertising industry itself, discussed below.

Regulatory Changes on Advertisers

The most significant change in advertiser industry was undoubtedly the withdrawal of K-12 education organizations following the Chinese government's sector-wide crackdown, which also included a ban on advertisements for education organizations (see our summary of the policy reforms here). Additionally, the suspension of banhao issuances starting July 2021 resulted in lower advertisement revenue from new games for which Tencent is a distributor since those games could not yet be monetized. To a lesser extent, the Chinese regulators also released additional restrictions on gaming advertisements, including a ban on the use of famous public figures for game promotions.

Other advertiser sectors have also faced tightening regulations over the past year or so, including the insurance industry, where a new rule was launched banning self-media advertisements for insurance products (e.g. to prevent social influencers from making misleading advertisements and to ensure that insurance companies are solely responsible for their advertising), and the real estate industry, where numerous local governments have stepped up to control potentially misleading advertising (e.g. mentions of very high expected returns) and curb rising housing prices through advertising restrictions (e.g. advertisers are now banned from promoting school districts associated with housing location*).

*Chinese school placements for elementary and middle school students are based on housing district, leading parents to fight for housing in districts with schools that have historically produced students with high college exam scores (see further information here). This competition has driven up housing prices in such districts relative to other districts in the same city with otherwise similar attributes.

Amidst all the regulatory changes, Tencent cites consumer staples as a relatively resilient advertiser category.

Regulatory Changes On The Online Advertising Industry

During the same time period, the Chinese government also launched regulatory measures targeting the online advertising industry itself. These include technical restrictions on launch screen advertisements (which limit the content and/or duration of advertisements that are shown when users launch an application) and requirements on click-to-close features (e.g. previously, some software applications in China had pop-up advertisements on the side that could not be closed), additional regulations for advertisements targeting minors and the elderly, and changes in personal information protection law.

Future Prospects For Tencent

Due to the significant changes in regulatory environment, revenue from social and other advertising fell 10% year-on-year while revenue from media advertising tumbled 25% year-on-year in 2021. The decline in media advertising revenue was particularly large due to fewer releases of drama series and variety shows in relation to the slower regulatory approval process, while the regulatory changes discussed above also had the impact of reducing Tencent's advertisement inventory. Management expects the online advertising business to resume growth in late 2022 as Tencent adapts to the new regulatory environment and further enhances the company's advertising solutions.

FinTech and Business Services

We move on to Tencent's fintech and business services segment, comprising of a financial technology (fintech) sub-segment that includes digital payment processor WeChat Pay and digital bank affiliate WeBank (see Part 1), as well as a sub-segment dedicated to cloud-computing related business services.

FinTech

While management does not touch on future prospects for Tencent's fintech business, we do not anticipate significant growth from this business area due to two main reasons.

First, WeChat Pay is a relatively mature business with limited growth prospects. Although Tencent's last reported number of WeChat Pay users was 800 million at the end of 2019, we expect this number to have risen since then to more or less equal rival Alipay's current one billion-plus users.

Second, the financial nature of the activities which Tencent's fintech segment is engaged in (particularly micro-lending, see Part 1), means the business will be subject to increasing regulatory scrutiny similarly to Ant Group (see our Ant Group series here and summary of new microlending regulations that hindered the Group's IPO here). We highlight that non-traditional financial intermediaries such as Ant Group (essentially a shadow bank) and Tencent's WeBank (a private digital bank) tend to have much larger risk appetites than China's traditional state-owned banks, with WeBank's involvement in the Danke (Chinese: 蛋壳公寓) real estate ponzi scheme as an example (see our Danke series here)

Business Services

Management's plans for Tencent's cloud computing related business services include promoting a more sustainable growth strategy, upselling existing cloud customers, and tapping into the continued rise of software-as-a-service (SaaS) computing as a key strategic growth driver for the company going forward. We explain these plans further below following a short primer on cloud computing.

Cloud computing services across the industry are available at three different levels:

Generally speaking, profit margins are highest for SaaS, followed by PaaS and lastly IaaS.

Tencent provides all three forms of cloud computing services, although the company primarily focuses on PaaS and SaaS (see Part 1).

A Shift Towards Sustainable Growth and Upselling Cloud Customers

Historically, Tencent was focused on aggressive expansion for the sake of obtaining customer relationships, albeit at the cost of steep price discounts and minimal or even negative margins. The company invested heavily in sales and marketing expenses to expand its customer network, in addition to taking on additional costs associated with designing custom-tailored solutions for clients and engaging in hardware resale contracts (i.e. Tencent might resell their hardware to clients upon termination of an IaaS contract) which severely reduced margins. Going forward, Tencent aims to promote more sustainable, cost-effective growth by developing a range of versatile, standardized products that are reusable across a wide range of customers. Management also states that they plan to be more disciplined in their approach to IaaS pricing, while also terminating the practice of hardware reselling at a loss. As PaaS generates substantially higher margins than IaaS, Tencent will also try to upsell customers from IaaS to PaaS.

SaaS As A Key Strategic Growth Driver

Tencent aims to tap into the continued rise of SaaS adoption among large and small corporates in China as a key strategic area of growth. Specifically, the company plans to strengthen its competitive edge by: (1) establishing corporate collaboration and communication tool WeCom (see Part 1) as the core platform for enhanced productivity and efficiency through the integration of Tencent Meeting and Tencent Docs (see Part 1), and (2) deepening the connection between Weixin (see Part 1) and WeCom in order to better facilitate customer relationship management (CRM) functions and allow corporates to deliver enhanced services to their customers. Tencent's SaaS business is incurring costs without significant revenue generation at the present, as management explains that the company is prioritizing scale expansion over significant revenue generation in the short to medium run.

Investment Portfolio

Lastly, we touch briefly on Tencent's investment portfolio (see Parts 1 and 2) to conclude.

In the company's most recent earnings call, management mentions that they intend to continue Tencent's historical strategy of making minor investments (as opposed to outright mergers or acquisitions) predominantly in private companies and helping those companies grow until they become public. Consequently, it is expected that Tencent will be continually divesting and reducing its stakes in publicly listed companies in order to fund new investments in private companies as part of its investment portfolio cycle going forward.

Tencent also invests in its own stock through share buy backs when management sees fit.

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Tencent (Part 2): Ecosystem Financials

Tencent (Part 3): The Future of Tencent

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