Tencent: Games Undergoing Internal Transformation, AI First Effectively Applied to Advertising Business (4Q23 Earnings Call)

The following is the summary of the financial report conference call for the fourth quarter of 2023 of TENCENT.HK, for financial report analysis please refer to "TENCENT: Game Soul Lost, Stock King 'Money Shower' Apology"

1. Review of Core Financial Information:

2. Detailed Content of the Financial Report Conference Call

2.1. Key Points from Executive Statements:

1) Financial and Business Overview:

a) TENCENT's total revenue in 2023 reached RMB 155 billion, a year-on-year increase of 7%; gross profit was RMB 78 billion, a year-on-year increase of 25%.

b) Breakdown of revenue: value-added services 45%, social networks 18%, domestic games 18%, international games 9%, online advertising 19%, financial technology and business services 35%.

c) Under non-international financial reporting standards, adjusted operating profit increased by 35% year-on-year, and net profit increased by 44% year-on-year.

2) User and Product Development:

a) Video account user total usage time doubled, DAU and single user time increased, and creator revenue grew rapidly.

b) Revenue from mini-game platform grew by over 50%, the number of hit games in China increased from 6 to 8, international game business revenue grew by double digits, accounting for 30% of total revenue. The two main games, "Honor of Kings" and "Peacekeeper Elite," maintained a leading position in daily active users, and the new monetization strategy is expected to improve results.

c) TENCENT Video and TENCENT Music have 117 million and 107 million paying users respectively, consolidating their leading positions in the industry.

d) Gaming business: domestic game revenue slightly decreased, while international game revenue increased year-on-year; it is expected that game revenue will improve from the second quarter of 2024.

e) User time for content consumption on WeChat video accounts increased by over 80% year-on-year, with a sharp increase in the number of creators.

f) Online advertising revenue increased by 21% year-on-year, video account advertising revenue doubled, benefiting from upgrades to the advertising technology platform and precise targeting.

g) Revenue from enterprise-level SaaS products such as TENCENT Meeting, TENCENT Document, and WeCom software business more than doubled year-on-year3) Performance of Financial Technology and Business Services:

a) Revenue from financial technology and business services increased by 15% year-on-year, with double-digit growth in financial technology services and approximately 20% growth in business services.

b) Gross profit margin increased significantly, with increased business payment transaction volume, wealth management fees, and consumer loan fees.

4) Technological Innovation and Application:

a) TENCENT's Huan Yuan model has reached top-level performance in Chinese language processing, especially excelling in advanced logical reasoning and numerical reasoning.

b) The application of AI technology in the advertising business is significant, as AI models for advertising have optimized ad targeting effects and increased advertising revenue.

5) Social Responsibility:

The digital public welfare platform helped raise 3.8 billion yuan in charity donations in 2023, and established the "Corner Scientists" program to support basic scientific research.

6) Financial Reports:

a) Total Revenue and Growth: In the fourth quarter of 2023, total revenue was RMB 155 billion, a 7% year-on-year increase. Revenue from value-added services in the fourth quarter was RMB 69 billion, a 2% year-on-year decrease. Revenue from social networking services in the fourth quarter was RMB 28 billion, a 2% year-on-year decrease.

b) Gross Profit and Growth: Gross profit in the fourth quarter of 2023 was RMB 78 billion, a 25% year-on-year increase. The gross profit margin for value-added services rose to 53.7%, a 3.9 percentage point increase year-on-year.

c) Operating Profit and Growth: Operating profit in the fourth quarter of 2023 was RMB 49 billion, a 35% year-on-year increase. Under non-International Financial Reporting Standards, operating profit was RMB 49 billion, a 35% year-on-year increase.

d) Net Profit and Growth: Non-International Financial Reporting Standards net profit attributable to equity holders in the fourth quarter of 2023 was RMB 43 billion, a 44% year-on-year increase. Net profit attributable to the parent company's shareholders under International Financial Reporting Standards was RMB 27 billion, a 75% year-on-year decrease.

e) Earnings Per Share (EPS): Diluted EPS under International Financial Reporting Standards was RMB 2.807, a 74% year-on-year decrease. Diluted EPS under non-International Financial Reporting Standards was RMB 4.443, a 46% year-on-year increase.

f) Financial Costs and Profits from Associates: Financial costs decreased by 3% to RMB 3.5 billion. The share of profits from associates and joint ventures was RMB 2.4 billion, showing improvement compared to a loss of RMB 1.6 billion in the same period last year.

g) Income Tax Expense increased by 111% to RMB 9.7 billion.

7) Cash Flow and Capital Expenditure:

a) Total capital expenditure in the fourth quarter was RMB 7.5 billion, a 33% year-on-year increase.

b) Free cash flow was RMB 34.2 billion, a 48% year-on-year increase.

c) Annual free cash flow reached RMB 167 billion, an 89% year-on-year increase. d) Net cash balance at the end of the period was RMB 54.7 billion, a 50% increase compared to the previous period.

8) Cost and Expense Control:a) Sales and marketing expenses increased by 79%, research and development expenses increased by 3%, while administrative and general expenses decreased by 6%.

b) Gross profit margin increased to 50%, a year-on-year growth of 7.4 percentage points.

c) Income tax expenses increased by 111% year-on-year to 9.7 billion RMB.

1. Cash flow and capital operations:

a) Full-year free cash flow increased by 89% year-on-year, and the net cash balance at the end of the period increased by 50% year-on-year.

b) It is proposed to increase the annual cash dividend by 42% to HKD 3.4 per share, and plans to at least double the HKD 49 billion repurchase amount in 2023 to over HKD 100 billion in 2024.

2.1 Q&A Analyst Q&A:

Q: Can you share the implementation timeline of the company's initiatives in online games and when they are expected to benefit the overall growth of the company's online games? How do you view the mid-term growth prospects of online games? What are the latest developments in live e-commerce, such as the current scale, future development plans, and how to differentiate from competitors?

A: The company believes that the main challenges it currently faces are not from external factors, but internal management and optimization. To address these internal issues, the company has adopted three strategies.

Strategy one, leadership changes for existing games to drive game revival by replacing leadership. Significant revenue growth has been achieved in games such as "Dream Star" and "PUBG Mobile" through these changes. For games that need adjustments, the company is actively taking measures to improve them.

Strategy two, focus on games that have accumulated a large user base in the past two to three years to enhance commercial monetization. For example, games like "Gold Shovel Battle," "League of Legends Mobile," and "Dark Zone Breakthrough."

Strategy three: Concentrate resources to launch new games with larger budgets and iterate based on past successful experiences. Several new games are expected to be launched this year, such as "Dungeon and Warrior Mobile," which has performed well in internal testing and is scheduled for early release in the second quarter of this year. The success of these strategies will determine the mid-term growth rate.

Live e-commerce progress: In 2023, live streaming and video account e-commerce made good progress, but it is only in the initial stage of nurturing this opportunity. GMV in 2023 increased significantly to over 100 billion RMB (should be on a payment basis), while the GMV of video account and mini-program e-commerce is still relatively small.

Future plans for live e-commerce: Upgrade overall ecosystem management, including improving product quality control, optimizing user complaint and feedback handling processes to enhance customer shopping experience. Strengthen category management, work meticulously on high-potential product categories to ensure high-quality merchants and products that attract consumers. Develop more tools for merchants and brands to help them with business analysis and optimize pricing decisions. Increase consumer awareness of the platform and products overall, especially on WeChat and video accounts, to increase the visibility of in-video shopping experiencesQ: Should we consider the challenges of weak monetization capabilities and weakened game growth as the new normal for domestic evergreen games? Does this mean that these games have now lost their growth potential? Does the company need to rely on the release of new games to drive growth? Regarding the market's concerns about the new draft regulations for the gaming industry in the fourth quarter, can the company provide updates on the latest developments on this issue? When will the new draft be introduced? How are these potential rules expected to impact the company's business?

A: The decline in performance in Q4 is a direct result of the weakening of the flow that began in Q2. The two main games of the company have a 9-month amortization period from total revenue to reported revenue, so the weakening of the flow that started in Q2 affected the performance in Q4. Although reported revenue declined year-on-year, actual cash inflow (total revenue) slightly increased in Q4. There is a time lag between cash flow and reported revenue, which will be reflected in the second-quarter income statement. The company has already experienced an improvement in cash flow. For the current situation of the gaming business, the improvement in cash flow is a positive signal, although reported revenue may still show a decline.

The company does not believe that the top games have lost their growth potential. Top games have a large user base and, although they may experience fluctuations, they will only become stronger in the long run, as seen in games like "Call of Duty," "Grand Theft Auto," and "Fortnite." In the Chinese market, although there may be a potential loss of growth, it is still a stable asset for us rather than a burden, similar to the luxury goods industry. Luxury brands that have lost their growth potential are not considered worse than emerging brands.

"PUBG Mobile" is experiencing a strong rebound, and the overall Supercell game portfolio is also rebounding strongly, with substantial rebounds expected in the company's other games as well.

The company is not aware of the release time or whether the new draft will be released. The initial concerns of the market are no longer the company's main focus after regulatory agencies clarified their intentions. Regulatory agencies have clearly stated that the purpose of the draft is to provide a healthy environment for industry development, not to restrict the industry.

After the market expressed initial concerns, the government took a series of supportive measures, including expediting the approval of domestic and imported game licenses, such as the company's flagship mobile game "Dungeon & Fighter" (DNF Mobile) receiving approval. The focus of regulatory attention is on games with high ARPU (average revenue per paying user), which is not relevant to the company. In fact, the company's ARPU is at a lower level compared to the entire industry.

Q: Apart from enhancing and driving internal advertising positioning capabilities, what are the expectations for AI functions to generate significant revenue from external cloud services and commercial service clients in the near future? Is this reflected in the continuous improvement of advertising ROI and e-commerce merchant conversion rates? The user profiles of mini-games are different from those of mobile app games. Are there any changes in user preferences or a shift in user time from app games to mini-games, which may have also led to the slowdown in domestic game growth over the past few quarters?A: The short-term benefits of AI are mainly reflected in the advertising business, as the advertising business is large in scale, even a small growth can bring substantial profits. With the continuous growth of the advertising business and the addition of the video account e-commerce ecosystem, there is huge growth potential on the advertising side, and currently, the advertising loading rate of video accounts is low.

For AI services for cloud and commercial service clients, they face a relatively emerging market that requires time and effort for sales, collaboration with clients from different industries, and exploration of the best ways to utilize AI. These businesses have characteristics of long sales cycles, intense competition, and low profit margins. Competitors may enter the market by lowering prices, even though their products may not be superior. These factors - low profit margins, high competition, and long sales cycles - are challenges that need to be faced in B2B businesses.

Therefore, from a short-term perspective, using AI to enhance the advertising business will be more profitable. However, the company will continue to focus on the mutual development of the advertising business and cloud and commercial service clients. The company not only focuses on profits from clients but also emphasizes how to improve clients' businesses in the long term. As the Chinese economy shifts towards a focus on productivity and with rising labor costs, having more profitable and service-oriented businesses will become important, but this will take time to achieve.

Regarding whether mini-games are cannibalizing the time or revenue of in-app games, the company is very confident that mini-games are not cannibals, but rather pioneers and explorers in a new field. In-app games have been performing well, and there is low overlap between users of mini-games and in-app games. From the perspective of user spending, there is even lower overlap between paying users of mini-games and in-app games, with almost no cannibalization between them. Therefore, the company believes there is no clear competitive relationship between mini-games and in-app games.

Q: How do you view the potential total shareholder return in 2024 and in the medium term? When measuring returns in USD or as a percentage of market value, which evaluation method does the company typically prefer, and how does it plan to reward shareholders? Regarding the video account e-commerce, can it be said that the company is ultimately building a more open trading platform rather than forcing all transactions through its own store infrastructure? Since mini-programs are more like a platform, would this be more similar to the e-commerce system built by Meta rather than a very closed system on a video platform?

A: Shareholder return: The company dynamically evaluates total returns, including more procedural measures such as dividends and buybacks, as well as more opportunistic distributions. This year, the company intends to return a significant amount of capital to shareholders. The portfolio has returned more capital to shareholders in the past two years than it has absorbed, achieving self-sufficiency even when excluding certain specific distributions, with new investments funded by divestments, dividends, or distributions from the existing portfolio. It is expected that the portfolio will continue to achieve self-sufficiency in 2024, making it a source of cash rather than a cash user.

Video account e-commerce: The company believes that in the future, there will be both open and closed platforms, each serving different purposes.** Open platforms, similar to mini-programs, are more suitable for widely recognized brands that typically have large proprietary channels to promote mini-programsHaving a large number of offline stores can guide customers to add mini-programs to achieve online shopping. Mini-programs need strong brand awareness to maintain user retention.

The disadvantage of mini-programs is that businesses find it difficult to acquire new customers online and mainly rely on their own channels. Despite these limitations, mini-program e-commerce platforms have still developed to a considerable scale. Video account live streaming platforms are closed platforms that require more active ecosystem management. This management ensures that the shopping quality is better than open platforms, especially for less well-known merchants. Video account e-commerce can leverage platform traffic to help businesses acquire new customers.

The company plans to connect open platforms (such as mini-programs) with closed platforms (such as video account e-commerce). This connection will be selective and planned to ensure mutual benefits. Open platforms will benefit from video account traffic, while small businesses can benefit from their private domain traffic. This connection helps different types of businesses maximize sales and consumer exposure.

Q: How much hype is there in the field of generative AI, how much real-world application is there, and what is the pace of development? What are the company's expectations and plans for regularly developing large new games (reaching the level of top games), and whether there are goals beyond the mobile ecosystem, such as expanding to console and PC platforms?

A: The application of AI in games has a boundary between hype and reality, depending on how far people are willing to look. The company is willing to view the application of AI from a long-term perspective. AI in areas such as NPCs, graphic content generation, etc., is expected to bring meaningful progress to games in the next few years (rather than months). The game industry has always been a blend of gameplay innovation and content enhancement. AI is expected to have the most impact on content updates, but talented individuals and teams are still needed to focus on innovative gameplay.

Overseas studios encountered some setbacks in the current game development cycle due to COVID, but these setbacks are now largely overcome. Productivity is believed to have returned to normal, and the company is optimistic about the future, expecting significant game releases both domestically and internationally.

The company has continued some traditional practices in game development while also trying new methods. The company focuses on fewer, larger-budget projects, aiming to make the most investment in key games. It focuses on two types of games:

One is games iterated based on successful IPs (such as the "King of Glory" series);

The other is pushing verified gameplay in specific areas to a broader market (such as applying the combat system of "Dark Souls" to "Elden Ring"). Leveraging the experience of existing games (such as "Naruto"), combined with the latest graphics and technology, to provide updates for new games like "One Piece". The company collaborates with multiple platforms, including user-generated content marketing and paid advertising marketing. These marketing strategies aim to enhance the company's position in AAA game releases and are expected to yield good results.

Q: Tencent recently increased its registered capital, how might this be used for consumer loans or overseas business? How will this affect Tencent's balance sheet, and can management update us on the growth strategy for the financial technology business in 2024?Can we better understand the cost advantages gained from adopting artificial intelligence, and how much growth potential can be expected from it in the mid-term? How long will it take for TENCENT to achieve this?

A: WeChat Pay has been approved to significantly increase its registered capital, with funds transferring from TENCENT's balance sheet to WeChat Pay. The capital increase acknowledges the growth of WeChat Pay's business scale and sends a positive signal for the company's future development. The financial technology strategy focuses on the payment platform as the core, continuing to strengthen the construction and reliability of the payment platform.

Plans include launching new features and improving the mini-program payment ecosystem to enhance the payment experience and strengthen the connection between merchants and consumers. Providing digital tools for small and medium-sized enterprises to improve business efficiency. Introducing new payment technologies (such as palm print payment) and enhancing the payment experience for foreigners in China. Committed to nurturing a more vibrant tourism industry in China, with the payment platform expected to grow along with economic growth, consumption growth, and the popularization of cashless payments.

Plans to introduce high-profit, high-value financial information services such as wealth management, loan services, and installment payment services, in collaboration with licensed financial institutions. The development philosophy of financial technology business includes full compliance, high-quality risk management, creating value for merchants and consumers, and establishing constructive relationships with licensed financial institutions.

The company plans to increasingly use technologies including generative artificial intelligence to accelerate animation content creation. Animation content creation is an important and profitable business for TENCENT Video, with potential applications in general code creation as well. The benefits of artificial intelligence will not be reflected in a significant reduction in costs, but in faster content creation and monetization.

The most direct and significant benefit is the increase in advertising revenue. Martin gave an example of how a 10% increase in click-through rate would bring additional revenue, gross profit, and operating profit. Emphasizing that 10% should be seen as the baseline for improving click-through rates, not the limit, as the actual improvement may be greater. We mentioned that the company's click-through rate has increased by 100% in the past 18 months, highlighting the potential of artificial intelligence in improving ad click-through rates and revenue. When considering the financial benefits of artificial intelligence, click-through rates and ad revenue are the primary factors to consider. The advertising business is a highly liquid business for the company.

Q: Regarding the recent collaboration with Douyin, we believe that this has had a significant impact on the entire gaming, live streaming, and industry. What changes do you think this collaboration has brought to us?

A: We provide more content that users can spread on short video platforms, including video accounts, Kuaishou, Bilibili, Bilibili copy, music, and so on. We are also actively investing in more aggressively promoting our games on short video services. This is the situation in game marketing.

In terms of live streaming and e-commerce, I think we have discussed it in detail, and I think it is very synergistic with video live streaming and video advertising. If we can actually achieve a closed loop, understand who the merchants are, what products have been sold, and how the user experience is after the sale, then our ability to increase conversion rates throughout the entire food chain will be strongerTherefore, for us, it is very important to establish e-commerce infrastructure and ecosystems in order to support the long-term and significant growth of our video ad business. On the other hand, I believe that local services are not actually our current focus. From our perspective, local services are more about content provision. So in this regard, we would actually consider collaborating with our partners, such as Meituan, who have been our close partners for a long time, to generate content and help us promote local services.

Q: Regarding cloud and artificial intelligence, on the cloud side, competitors have recently announced a fairly large-scale cloud service price discount. What do you see in terms of enterprise situations? What is the current demand for AI and the most important price elasticity? How should we consider your positioning in large language models?

A: The prices in the cloud industry continue to decline, leading to cloud service providers continuously reducing the costs passed on to customers. This price reduction is a continuous trend in the industry, closely related to the decrease in computing costs. Cost competitiveness is key for cloud service providers, requiring scale and supply chain optimization to achieve. Supply chain optimization helps to lower input costs faster and further reduce output costs.

The company is transforming infrastructure into platforms, such as security, real-time communication, databases, etc., and upgrading to software as a service to provide more value to cloud customers. The GPT model has reached the top level in Chinese proficiency and has performed well in multi-turn dialogue, logical reasoning, and numerical reasoning. The model is text-based and has been extended to text-to-image and text-to-video functionalities. The company will continue to strengthen the basic capabilities of the GPT model and develop text-to-multimedia capabilities, especially in long videos and content-driven businesses related to core operations.

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