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Morningstar | Slower Growth at Tencent in 1Q; We Expect Growth to Accelerate in the Rest of the Year

For the first quarter of 2019, wide-moat Tencent’s revenue grew 16% year on year, mainly driven by 26% growth in the new segment, fintech and business services. The fintech and business services segment accounted for 26% of revenue, with financial technologies such as commercial payments and microloans contributing the majority of the revenue. Operating profit (which excludes interest income and other gains and losses, unlike reported operating profit) was up 10% year over year, with a 160-basis-points decrease in margin. This reflects the general trend of mix shift toward lower-margin digital content business and fintech and business services. Net profit was up 17% from a year ago to CNY 27.2 billion, helped by CNY 3.5 billion higher net gains. WeChat’s monthly active users grew 1% sequentially to 1.1 billion in the first quarter. We have raised our fair value estimates to HKD 510 per share to account for the time value of money. We continue to think Tencent has a lot of monetization potential that is not fully priced in.

Gross margin in the quarter was down 380 basis points year over year, offset by some nonrecurring events. These include lower video content costs in the advertising business due to the delayed launch of certain dramas. Gross margin for fintech and business services was 28.5%, rising 2.4 percentage points compared with the same period last year, despite a loss of interest income from custodian cash accounts since January as per People's Bank of China guidelines. Although the competitive landscape will dictate the need to increase subsidies in the future, Tencent did some operational changes to improve margins in the fintech business. These include offering loyalty program points rather than free withdrawal quotas to mom-and-pop merchants and charging a higher take rate in verticals such as small restaurants.

The most watched online games segment’s revenue was down 1% while cash receipts increased 10% year on year, with the difference due to deferral policy for virtual items sold. Perfect World Mobile generated daily average cash receipts of over USD 4.5 million or CNY 31 million in the first 22 days after its March 5 launch, according to online media citing Sensor Tower. This run rate implies a cash receipt of CNY 9.4 billion for the rest of the year, or 9% of 2018 game revenue. According to local media citing Sensor Tower, Tencent’s new game, Peacekeeper Elite, a replacement for the popular survival shooter game PUBG that could not be monetized in China, generated USD 20 million or CNY 138 million in the first five days in the app store after launching May 8. Such a run rate implies a cash receipt of CNY 6.6 billion, or 6% of 2018 online games revenue. Spending on games will normalize over time, these data do not cover Android phones, and revenue deferral can range anywhere from 6 months to 18 months. However, we think the initial spending provides comfort to our assumption of online game revenue recovery, which we assume to be 16%, in 2019 and 2020. To revitalize growth in gaming, Tencent is introducing season passes in several key games in China to increase engagement, monetization, and pay ratios. Tencent will also develop more games to publish internationally in the medium term.

Advertising revenue was up 25% compared with the same quarter last year, a slowdown from 38% in the fourth quarter. Other than the weaker macro and higher supply, the fact that Tencent did not air certain top-tier dramas in the quarter put pressure on growth. However, we think growth will pick up as WeChat Moments will release three ads per person per day in first-tier cities, up from two ads previously. In the first quarter, social and other ads accounted for 74% of advertising revenue. WeChat Moments ads are a large chunk of social and other ads.