Disclaimer: These notes are shared for informational and educational purposes only. THIS IS NOT INVESTMENT ADVICE.

Tencent announced 1q19 results on May 15. As you can see, I’m getting around to publishing my notes on Tencent’s earnings quite late here. In the future, I will post my thoughts sooner.

Key Takeaways:

  • New business segment “FinTech and Business Services”
  • Cloud services are the “business services”
  • Sales channel for business services will revolve around “showcases”
  • Content delays still impacting advertising revenue (same with iQiyi)
  • Gross Margins declining slightly, Adjusted EBITDA margins steady

New Segment: FinTech & Cloud

In China Tech Investor episode 19 we talked about Tencent’s 4Q18 earnings and I speculated the new segment would be cloud and financial services. And that I was looking forward to how they describe this.

  • New segment: “FinTech and Business Services”
    • Payments, wealth management, other Fintech services
    • Cloud services, other 2B services
  • “Others” now is production and distribution of films, TV programs, copyrights licensing, merchandise sales and others.

Segments

It’s good to occasionally make a list of what a company does, to get a feel for what a company is that is different than the corporate message.

Trying to ask “what is Tencent?” by looking at their segment revenues, you’d think they are first an Online Gaming company, second a FinTech company, and third a Social Network. And that isn’t wrong per se.

A better way to frame Tencent may be (1) a Publisher and Distributor of online games, video, and text content; (2) a Service Provider of payment, cloud, and advertising services; and (3) a Platform Owner/Operator of social networks.

This is important because the framing informs how to think about the company’s competitive positioning. (I’ll write more on this in the future.) Let’s dive into the segments given.

Fintech & Biz Services

Fintech & Cloud (as I want to call it) had an uptick in gross margins despite losing interest income on custodian money to PBOC. Mainly due to: (1) no longer giving exemptions or subsidies on cash withdrawal fees, now have a loyalty points system; and, (2) certain verticals take rates are back to a normal level, restaurants was given as an example. Shen Hon Lo (CFO) mentioned the margins will be impacted by competitive landscape as they dial up or down promotions and subsidies.

For cloud, it’s losing money on an operating basis, but certain verticals have made “decent progress”, those are: smart retail, financials, and municipal services. I think these are more like a handful of projects as opposed to “decent” adoption. This is where “2B showcases” come in. 

With the shift to 2B or “enterprise” as Tencent calls it, most people were excited for potential TAM expansion (more revenues). I’ve talked about how this is likely to lead to greater costs, hiring and training new teams to go out and sell to businesses. Tencent’s management has said as much on the call. 

They can hire a small team and have them go do the hard 2B sales work, but… “..it’s actually not that scalable, right?” says Martin Lau (P), “Every single company will need a team of tens or even hundreds of IT people to create custom-made solution.”

The WeChat Advantage

Even though it’s hard to scale “2B”, Tencent has a unique competitive position with Weixin/Wechat in Mini-Programss, Official Accounts and payments. Retailers have an easy path to “digitalization” through Wechat by utilizing advertising, Mini-Programs (MPs), payments and Official Accounts (OAs). Because Wechat is a daily must-use utility, it means retailers have increased opportunity to connect with their customers.

The obvious downside here is the potential to ‘poison the stream’. If WeChat turns into a spam sandwich, users won’t be happy. The easiest way combat this potential is giving users easy-to-use control over the “flow” of messages from OAs and MPs. Keeping users happy is far more important to WeChat’s ecosystem and worth the tradeoff of making it a bit more difficult for advertisers.

“We don’t think of WeChat as just a messaging app, we think of it more like a public utility service

Dowson Tong, Senior Executive Vice President of Tencent and President of Cloud and Smart Industries Group [1]

Online Advertising

All the big tech companies with advertising revenues have taken a hit in that revenue segment in the March quarter. In addition to the usual seasonality with advertising in 1Q, part of the reason is macro, content regulations, and specific verticals scaling back ad-spend (autos, real estate, internet services). 

James Mitchell also mentioned the “big, established but not-yet-profitable O2O companies and some internet start-ups who have curtailed their spending.” (A bit of a jab at Meituan-Dianping? LOL) On the other hand the relatively robust sectors are consumer products, games, education.

Internet Value-Added Services

“Retention for Peacekeeper Elite has been good,” as said in mid-May. We can see that because Peacekeeper Elite grossed $49.2m in May. Epic. I doubt they’ll keep that run-rate though. It could be people are making up for lost spending on PUBG mobile in China that never got monetization approval.

Source: SensorTower, Bloomberg

An important question is what kind of margin can Tencent get on Peacekeeper Elite. James Mitchell wants to see how game monetization behaves before going into that. I guess that could mean there is a revenue sharing agreement(s) with ratchets/targets. They do own a stake in PUBG creator BlueHole and have been trying to increase that stake…

James Mitchell went into details on the Season Passes. They noticed improved engagement, improved paying-ratio, and they aren’t seeing Season Passes pulling forward revenue, which means it is potentially accretive.

Group Margins

Margins had an uptick, though GM is lower YoY. The larger uptick in Net Income due to “Other gains, net” which is fair value gains of investee companies and net disposal gains from “capital activities of certain investee companies”.

Gross margins have declined but Adjusted EBITDA margins are holding steady. This compares to declining Adjusted EBITA margins at Alibaba, as they have entered, to borrow James Mitchell’s turn of phrase, the “not-yet-profitable O2O” competition.

Earnings Call Highlights

Daniel Zhang (?): “decade-long investment in FinTech and Business Services prove that our strategy of allocating capital to a range of organic investments can expand our capabilities, broaden our revenue base as well as generate sustainable profitable growth”

James Mitchell: “Looking forward, as we mentioned in the prepared remarks, we believe that there’s a convergence underway between the China game market and the rest of the world, Western game markets. That’s convergence in terms of the platforms on which people are playing games, meaning PC, console, mobile, it’s convergence in terms of the game business model meaning that the shift to the free to play games. And it’s also convergence in terms of the genres of games that people like, meaning the, for example, first-person shooter games which historically were less popular in China, have now become more popular in China. So given those convergence trends, we are more closely reviewing future games to assess whether they are suitable for global publishing as opposed to just China publishing.”

Earnings Call Q&A

Question on advertising business

JGM: In addition to macro environment, delays in several top-tier drama series were expected to be broadcast in the first quarter and were not broadcast in Q1. Negative impact on media advertising.

Within advertising revenue mix, some products have more direct competition and some have less.

“The macro environment will be whatever it will be.”

Question – Margin profile? Is fintech gross margin above 30%? Take rates on payment business?

ML: Don’t separate out cloud and fintech. Fintech is much larger %age.

Take rates are lower than global peers, similar to how credit card take rates are lower than global peers. Chinese credit cards are a better benchmark.

“I think it’s really because of the fact that the Chinese economy was actually built — the payment infrastructure was actually built at a later time and as a result, it’s somewhat reflective of a lower cost.”

Sources

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