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Morningstar | Tencent’s Weak 2Q No Threat to Its Wide Moat Rating and Long-Term Growth Outlook

We remain positive on wide-moat-rated Tencent for its long-term growth outlook, but near-term uncertainty has risen because of the lack of visibility over the launches of new gaming titles. However, we had already factored in slower growth in 2018 due to the delays in approval for game monetization, and our earnings forecast is 10% below market consensus. We think the delay merely pushes off growth to 2019, when we expect game approvals to resume. Hence, we make little change to our key assumptions, but lift our full-year net profit forecast to CNY 74.6 billion from CNY 66.6 billion, to factor in noncash items classified in other gains. However, we lower our fair estimate to HKD 590 per share from HKD 641, after taking into account an 8% depreciation in the Chinese yuan against the Hong Kong dollar. We think the recent share price weakness present an attractive buying opportunity, with the current price level not fully reflecting Tencent’s monetization opportunities, supported by the company’s strong network effect built on its massive user base and ecosystem.

Recent market jitters were driven by net revenue growth slowing to 30%--the slowest pace since third-quarter 2015--and a 2% year-over-year (23% quarter-on-quarter) decline in net profit. The slowdown reflects a lack of new game launches, which is leading to concern that the Chinese government is clamping down on gaming. While this is not confirmed, we would not be surprised to see no or slow approvals for 2019 because of an ongoing restructure of the administrations governing this space. While the approval process of new game titles remains cloudy in the near term, we think revenue could be less impeded going forward because Tencent has a pipeline of 15 games approved for launch, of which five are expected in the third quarter. Tencent has a chance to see its gaming revenue pick up.

Despite the near-term headwinds in online games, we think Tencent’s core strength in gaining traffic from its massive userbase is unchanged. The combined monthly active users, or MAUs, of Weixin and Wechat contined to rise 9.9% year over year in the second quarter, or 1.7% on a sequential basis. Meanwhile, fee-based VAS registration subscriptions rose 30.3% year over year in the second-quarter, or 4.6% on a sequential basis. With MAUs exceeding 1 billion, Tencent’s Weixin and Wechat platform covers more than 75% of the China’s population and forms a solid base for the company’s long-term growth and monetization opportunities. In addition, we think Tencent’s rapid growth in Mini Programs offers a bright spot, which further strengthens the platform's level of user engagement. Since its launch in January 2017, daily active users have continued to grow, reaching 200 million in the second quarter, with public transportation, smart retail, restaurants, and Mini Games the main use cases. Tencent is testing the water with monetizing Mini Programs through in-game advertising, in-game purchases, and payments, but it will prioritize building the Mini Programs ecosystem and improving the user experience over rapid monetization.

The year-over-year revenue growth in Tencent’s mobile game slowed to 19% in the second quarter, from 68% in the preceding quarter and 54% a year ago, due to the lack of monetization approval of PUBG mobile in China, despite upward trends in both DAU and time spent. We think regulatory risk remains the near-term challenge for Tencent, as the restructuring between the Ministry of Culture and Tourism and the National Radio and Television Administration has resulted in a temporary suspension of game monetization approvals since March. According to management, Tencent has more than 15 games obtained monetization approvals, and five games will be officially launched in the third quarter. In addition, Tencent plans to roll out expansion packs for its existing titles and expand storylines to prolong monetization. These will help to boost revenue growth for online games in the second half.

Other businesses continue to see solid growth. The cloud base expanded significantly, driving a doubling in revenue from a year ago. Tencent Video maintains its leadership in online video platforms, with subscribers up 121% year over year, outperforming the 75% growth rate at its key competitor iQiyi. In addition, despite slower growth of 16% for media advertising, social and other advertising revenue increased 55% year over year. Payment continues to see decent growth, with MAUs surpassing 800 million and daily transaction volume up more than 40%. However, the People's Bank of China's recent decision to raise the custodian deposit rate to 100% from January 2019 should mean Tencent will no longer benefit from the interest income from restricted custodian deposit. We estimate the negative impact should be about CNY 2 billion, which we have already factored into both our earnings forecasts and fair value estimate.