Tencent: Gaming Sector Struggles, "King of Stocks" Spends to Salvage Reputation

After the Hong Kong stock market closed on March 20th Beijing time, the quarterly report of Tencent ($TENCENT.HK) was released. The key point is the doubling of share buybacks, with the company expected to repurchase over 100 billion in 2024. When considering dividends, the potential dividend yield exceeds 5%.

In terms of performance, the overall situation was relatively lackluster due to the drag from the gaming sector. Revenue growth slowed to single digits, but profits maintained a high growth rate, mainly due to changes in business structure (incremental revenue from high-margin businesses such as Video Accounts and Mini Games, significant decline in low-margin businesses like live streaming due to proactive adjustments), as well as some cost reduction measures implemented internally, leading to a significant increase in gross profit margin.

However, the company spent an additional 2 billion in marketing expenses in the fourth quarter, resulting in core operating profits slightly below expectations. Needless to say, the majority of these expenses were used for "Dream Star". The actual effect can be seen as well, as this intense "billion-dollar business battle" has actually benefited the competitor "Egg Party" at least for now.

Looking at the fourth quarter alone, there may have been some mismatch between investment and returns, but the key is the solid growth in gaming revenue. From the perspective of the three major businesses, this year's valuation upside still relies on making new achievements in the gaming business. Unless the second driving force, which is Video Accounts expanding into e-commerce, progresses smoothly, however, it is believed that, based on the current user data of Video Accounts (especially user stickiness), e-commerce is not enough to make up for the gap in gaming.

Currently, during the Chinese New Year period, older games such as "King of Glory" and "LOL Mobile Games" have performed well, and the upcoming heavyweights include "DNF Mobile Game", followed by several high-quality shooting games, as well as whether "Dream Star" can thrive after perfecting its UGC ecosystem like "Egg Party" did in the beginning.

Key points to look at in the financial report:

1. Overall: Slightly higher profits, revenue in line with the latest market expectations after downward adjustment

Tencent's overall revenue in the fourth quarter was 155.2 billion, a year-on-year increase of 7.1%, with a noticeable decline compared to the previous quarter, also lower than market consensus expectations (Bloomberg). However, it was observed that some top investment banks had already lowered revenue expectations in early February, and compared to the latest expectations, they are largely in line, indicating that the current stock price may have partially priced in the relatively weak revenue growth in the fourth quarter.

Due to a significant improvement in gross profit margin, despite a sharp increase in marketing expenses, the final Non-IFRS attributable net profit accelerated by 43%. Excluding minor adjustments such as amortization, depreciation, and equity incentives, the core operating profit growth of the main business, although slowing down compared to the previous quarter, still achieved a 39% growth, even though the fourth quarter of 2022 was not a low base period2. Business Segmentation: Gaming Lags Behind, Advertising Shines

(1) Gaming: Both domestic and overseas markets performed poorly in the fourth quarter. In the domestic market, not only are there few new games, but there is also a delay in producing the next blockbuster game. In the overseas market, due to the high base number from last year and the slowdown in market recovery, the performance naturally declined.

The issue of Tencent's difficulty in producing new games has been particularly prominent in the past two years. Games are still the main business affecting Tencent's fundamentals and valuation in 2024 (followed by the e-commerce through video accounts). However, the market's expectations for games are still leaning towards caution.

(2) Advertising: Surprisingly exceeded expectations. Originally, the company's guidance and information from market experts indicated that the growth rate of Tencent's advertising in Q4 might decline significantly due to the high base number. However, the actual growth rate remained at 21% year-on-year, the same as Q3. Dolphin believes that the advertising revenue from video accounts and mini-games may still be the main driving factor.

(3) FinTech and Cloud: Basically in line with expectations. On one hand, there is a pure incremental increase in commission income from video accounts, and on the other hand, the cloud business is completing its adjustment cycle and returning to growth. In addition, the payment business may still be gaining market share. Compared to the single-digit growth in third-party payment transactions in the industry, Dolphin believes this may indicate that WeChat Pay continues to steadily gain market share.

(4) Digital Content: Excluding games, value-added services consist of digital content services such as Tencent Music, Yuewen Group, Tencent Video, Huya Live, and QQ Show. Tencent Music and Yuewen Group are both undergoing active adjustments in their businesses, Huya Live is influenced by industry trends, so they are not contributing incremental revenue. However, their cost reduction measures can still help improve the overall profitability of the group's value-added services.

Considering deferred revenue and the upcoming game pipeline, we believe that in the first quarter, VAS may still face pressure due to adjustments in live streaming, weak performance in long videos, few potential blockbuster games (all after the second quarter), and the impact of a high base number.

3. Dividends and Buybacks: In 2023, the company repurchased a total of 152 million shares, consuming HKD 49.4 billion. In the fourth quarter, the company repurchased 44 million shares, consuming HKD 12.6 billion. The repurchased shares have been cancelled, and the diluted share capital decreased by 36 million shares compared to the previous quarter.

Since the major shareholder announced "indefinite reduction" in the middle of the year, Tencent has been increasing its buybacks. During the extreme market conditions from the end of last year to the beginning of this year, Tencent's buyback efforts intensified once again - with a year-on-year increase of +200% on a single day at the beginning of the year, and a 50%-100% increase from Q4 on a quarter-on-quarter basis. The company disclosed that the repurchase amount in 2024 will exceed HKD 100 billion, doubling directly from last year's HKD 49 billion.

In addition, the company announced a dividend of HKD 3.4 per share in 2023 (compared to HKD 2.4 per share in 2022, with dividends of HKD 22.7 billion already paid in 2023), equivalent to 25% of the full-year net profit attributable to shareholders being distributed as dividends.

If it is expected that the dividend in 2024 will be HKD 32.2 billion based on 2023 figures, with a 20% increase, along with a share repurchase amount of HKD 100 billion, the potential return corresponding to dividends and repurchases would be HKD 138.6 billion, with a dividend yield exceeding 5%. Dolphin estimates that Tencent uses 75% of its annual net profit to reward shareholders.

4. Overview of Financial Report Details

Dolphin's Viewpoint

The gap in gaming has always been filled by short videos, mini-games, and a stable payment business. However, if the gaming sector continues to underperform, it will further deepen the impact on Tencent's fundamentals. Therefore, the upward momentum in valuation in 2024 still relies on a turning point in gaming, as well as the progress of short video e-commerce expansion.

The collapse of the halo of "Dream Star" has actually intensified market concerns about Tencent's game development capabilities, lack of innovation, and weak operations. For Tencent, where 1/4 of its revenue comes from games throughout the year, this is an important issue to watch. Fortunately, the approval for game licenses has been strong. In early February this year, Tencent finally obtained the official license for "DNF Mobile," a classic IP game that has been delayed for years due to its development and policy reasons. Although it has been delayed for many years, it will have a certain impact on the core user base, but at least it is a rare new game worth looking forward to from Tencent in recent years. Currently, the performance of DNF PC game is relatively stable, so the performance of the mobile game is expected to reach a scale of 5-10 billion.

The user penetration of short videos has reached a certain stage, and the company's monetization demands are increasing. However, with the experiences of Douyin and Kuaishou, monetization still relies on e-commerce, whether it is commission income or internal circulation advertising revenue. This is the inevitable path for short videos to increase from the current annual revenue of 15 billion to 30 billion or even 50 billion. Recently, the company set a goal for the GMV of short video e-commerce to double this year. Currently, 15% of the revenue from short video ads comes from live e-commerce, but this figure is at 50% for Kuaishou and Douyin.

In addition, the installment payment business in the financial technology sector is also seen by Dolphin as a potential gold mine that may play a growth driver in the medium to long term. However, Tencent's promotion pace is not fast at the moment, likely due to regulatory considerations.

The above three points indicate that Tencent is not completely lacking in growth points. If operated normally, maintaining revenue growth in the double digits is still a relatively promising growth trend. However, past experiences and current operational issues may cause market concerns about the timing and effectiveness of growth realization.If a worse scenario occurs, Tencent may become a platform company with no revenue growth, relying on its own economies of scale to barely maintain low-profit growth. In this case, the valuation logic for Tencent will actually change. At this point, Dolphin Jun tends to provide a relatively conservative bottom valuation from the perspective of cash flow and even absolute returns from dividend repurchase earnings.

Based on the situation in 2024, Tencent's potential dividends + repurchases total 138.6 billion, with a dividend yield of over 5%, slightly higher than the current US Treasury yield. However, in the global trend of interest rate cuts and the potential future distribution of equity assets as physical dividends (such as Kuaishou), the current market value is already close to the bottom. Looking at marginal changes, Dolphin Jun still leans towards expectations for the intensive release of new games in the second quarter, so after digesting the flat Q4 and Q1 performance, with the return of repurchase dividends and game revenue growth, there is hope to see the valuation recover.

Below is a detailed analysis:

I. User Ecology: WeChat steady growth, QQ seasonal decline

In the fourth quarter, WeChat had 1.343 billion users, with a net increase of 7 million, maintaining stable expansion. QQ, on the other hand, continued to lose 4 million users under the pressure of the off-season.

While WeChat traffic stability can support the deepening commercialization of the WeChat ecosystem, the decreasing number of young users and the inability to retain them seem to have set a trend of QQ's difficult-to-change loss.

II. Game Growth Remains a Challenge

In the fourth quarter, online game revenue was 40.9 billion, a 2% year-on-year decline. Despite the relatively low base in the same period of 2022, facing pressure from the lack of strong new games, a slight decline in flagship game "Honor of Kings," and significant declines in games like "Peacekeeper Elite," Tencent still faces significant pressure.

Looking into details, both the domestic and overseas markets were weak in the fourth quarter. Although "PUBG Mobile" continued to rebound strongly and "Valorant" also contributed incrementally, the high-growth overseas market, which has been growing rapidly for a year, quickly fell back under a high base (in 2022, there were "Triple 3D," "NIKKE," "Fantasy Tower"). Dolphin Jun believes that the base issue may not be the key factor, the core issue lies in Tencent's slow new game development speed, lackluster operations, the slowdown of game rebound in overseas markets, and the increasing market competition due to more competitors entering the overseas market

The domestic market is also limited by the lack of new games (mostly agent games, with only "High Energy Heroes" and "The Division 2" developed in-house, and the new games launched in the first three quarters either have low revenue and are difficult to carry the burden, or they quickly fade away after the promotion period, revealing their true colors), especially high-quality new games with explosive potential.

However, as the industry continues to recover (although the growth rate slowed down in Q4, the rebound is strong enough), Tencent's games have been mediocre throughout last year, highlighting its own problems more and more. Of course, there has been continuous market discussion about the lack of innovation in Tencent's games over the years.

Dolphin believes that Jack Ma's criticism is still sharp and to the point - some teams have been basking in past glories for too long. The evergreen games from the early years have covered up the repeated failures of the team in new projects, which is actually a problem of declining capabilities. If team members do not excel, eliminate the inferior, and innovate, then their ideas and strategies will only lead to a dead end on the old and wrong path. "Blood transfusion" may be the self-revolutionary path that Tencent's games need to put on the agenda.

Looking ahead to the game pipeline for Q1 of this year and the full year of 2024, Dolphin believes that the key to whether games can still have hope lies mainly in "DNF Mobile" and whether "Star of Yuanmeng" can replicate the success of "Egg Party" after improving its UGC ecosystem. Although delayed for too long due to policy reasons, the performance after launch may not be comparable to the expectations of a few years ago, but the IP value is very high, and the first year's TTM revenue still has the potential to reach 5-10 billion.

In addition, several shooting and racing games are also expected to be launched in the second quarter and beyond. Considering the high base in the first quarter of last year, even with the pure increment of "Star of Yuanmeng," there is still some pressure on game revenue in Q1. The significant recovery is expected to be seen after the second quarter.

On the other hand, short-term game expectations can also be cross-validated from deferred revenue. Deferred revenue in the fourth quarter was 86.2 billion, a year-on-year increase of 4.8%, similar to the third quarter. With the low base last year, the incremental boost from the launch of "Star of Yuanmeng" half a month ago has not yet been clearly reflectedAlthough deferred revenue includes not only games, but also music subscriptions, long video subscriptions, and live broadcast recharge revenue, the year-on-year growth trend of the entire value-added service revenue is clearly downward. As the main contributor, games are difficult to avoid the same weakening trend. The revenue that can support the next quarter is not much, and it still depends on the performance of Q1.

From third-party data, apart from the multiple Spring Festival promotions of "King of Glory" and the situation of user-side game-to-mobile game conversion in "LOLM", the growth of other old games is generally average. Even the well-resourced "Star of Yuanmeng" lagged behind "Egg Party" during the Spring Festival, so purely looking at the short-term growth rate in the first quarter, there is still expected pressure.

In the digital content of value-added services, including Tencent Music, Yuewen, Huya Live, and QQ Show payments, mainly fall under social network revenue. Social network revenue in the fourth quarter decreased by 1.4% year-on-year, mainly due to the decline in online literature payments, live broadcast payments, etc. Although Tencent Video experienced a trend of user loss throughout the year, the explosion of "Blooming Flowers" in the fourth quarter offset the off-season impact, stabilizing the user decline trend, and maintaining the scale of paid members at 117 million.

III. Unexpectedly Strong Advertising Revenue

Tencent's advertising revenue growth rate in the fourth quarter maintained at 21% year-on-year, which is better than the company's guidance and market expectations. The incremental impact of video ads has already started in the fourth quarter of 2022, so there is no low base dividend from the first three quarters. Including third-party research information at the beginning of the year also indicated that Tencent's advertising growth rate in the fourth quarter would slow down, so maintaining a 20% growth rate is still very good.

In the fourth quarter, advertising revenue reached 25.7 billion, and based on a rough estimate by Dolphin Jun, excluding the incremental impact of video ads, the remaining advertising growth rate also showed a clear warming and acceleration in the fourth quarter. In addition to the boost from the peak season of e-commerce, Dolphin Jun believes that the advertising revenue sharing of mini-games mentioned by management multiple times also made a significant contribution to the increment.

Furthermore, media advertising may have also slowed down the declining trend. In the fourth quarter of last year, Tencent Music's advertising growth was good, and Tencent Video also had the explosion of "Blooming Flowers", which is expected to bring certain contributions as wellWhile the overall internet advertising market rebounded during the same period, Tencent's growth rate still far exceeds the industry.

Looking ahead to the first quarter, although macro expectations were poor from the end of last year to the beginning of this year, Dolphin Jun is not pessimistic about advertising growth. On the one hand, considering the launch of the e-commerce New Year Festival (with the addition of Douyin this year), and on the other hand, the offline consumption during the Spring Festival is hot, which is expected to drive business expectations to rebound. In addition, there is still a low base growth dividend for video accounts and mini-program games in the first quarter.

IV. Jinke Enterprise Services maintains steady growth

In the fourth quarter, Jinke's revenue from enterprise services increased by 15% year-on-year, basically meeting market expectations. Dolphin Jun believes that in addition to the steady increase in market share of WeChat Pay (comparing year-end social zero, the third-party payment industry growth rate is only 7%), the commission income contributed by video accounts, and enterprise services mainly focused on cloud services may have completed the business adjustment cycle.

V. Investment income mainly consists of profit sharing and subsidies

In the fourth quarter, Tencent's other income outside its main business was 1.35 billion, mainly subsidies and tax refunds. Profit sharing from associated/joint venture companies was 2.5 billion, indicating that the profitability of invested companies is gradually improving. However, if we simply look at the income from the appreciation of investment assets, it has been basically breakeven over the past year.

As of the end of the fourth quarter, the scale of the company's associated/joint venture assets was 261.6 billion, with a profit sharing of 2.5 billion for the period, and the quarterly investment return rate continued to increase to 0.9%.

VI. 2 billion for "Dream Star of Yuan", with mismatch affecting the current periodIn the fourth quarter, despite pressure on revenue, profits continued to maintain high growth. This is mainly due to the unexpected improvement in gross profit margin brought about by changes in business structure. Additionally, the decrease in server bandwidth costs, personnel expenses, and reduced new investments due to internal resource reuse also contributed.

We attribute this to the overall improvement in the company's cash realization efficiency, adjusting the low-margin live broadcasting business, while the newly added revenue from video ads, commission income, and revenue sharing from mini-games are all high-margin businesses. Furthermore, the improvement in gross profit margin of the Golden Technology enterprise is more related to the self-adjustment of cloud services (reducing low-margin subcontracting business), thereby optimizing related server costs.

However, operating expenses in the fourth quarter surged by 14% year-on-year, mainly driven by sales expenses. Although there is an impact from a low base, it still exceeded market expectations and seasonal changes. It is believed that most of the nearly 2 billion excess should have been spent on the launch promotion of "Dream Star". Looking at the detailed breakdown of promotional expenses, in the fourth quarter, under a low base, it more than doubled year-on-year.

Meanwhile, research and development (R&D) + management expenses remained flat year-on-year. Looking at a quarter-on-quarter basis, the number of employees increased by more than 100 in the fourth quarter, but average benefits declined. With the increase in R&D personnel, the total salary expenditure for R&D personnel alone did not increase. From this, it can be seen that although Tencent has returned to investing in business expansion, the overall pace is relatively relaxed to ensure the stability of basic expenses.

Of course, from the current strategic direction of the group, it is unlikely to see the kind of massive investment seen in previous years. On one hand, there are regulatory restrictions (anti-monopoly, etc.), and on the other hand, it is due to the group's stricter control over profit fluctuations, based on a commitment to stable operations and shareholder responsibility. Even when expanding business, the group will continue to improve operational efficiency.

In the end, in the fourth quarter, Non-IFRS net profit attributable to equity holders reached 42.7 billion, accelerating by 44% year-on-year, exceeding market expectations (after revision). Dolphin Jun also pays close attention to the operating profit situation of the main business, which grew by 39% year-on-year in the fourth quarter. Although the growth rate continued to slow down quarter-on-quarter, achieving this growth rate under high base and revenue pressure is already commendable.Seven, Selling Pressure and Repurchase: Major Shareholders Keep Selling, Repurchase Doubles

In terms of daily repurchase volume, Tencent continued to increase its repurchase in the fourth quarter. In the fourth quarter, 440 million shares were repurchased, consuming HKD 12.6 billion, and the repurchased shares have been cancelled.

Compared to our statistics in November last year, major shareholder Prosus has sold another 76 million shares from November 16 to the present four months, basically following a pace of selling 10-20 million shares per month this year. Currently, the shareholding ratio has dropped to 24.7%.

For more information on repurchases and sales, please refer to the repurchase review "Tencent: Major Shareholders Keep Selling, Can the Stock King Still Have Faith?". Due to space constraints, details are not elaborated here. The latest repurchase data and major shareholder selling pressure data will be regularly updated in the "In-depth Data" section.

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