Holding a New "King," Tencent Clashes with Channels Again

On the occasion of the upcoming one-month anniversary of the launch of "Dungeon & Fighter (DnF) Mobile Game", $TENCENT(00700.HK) immediately dropped a "bomb" - the DnF official website announced that starting from June 20th, due to contract expiration, the DnF mobile game will no longer be available on some Android platforms' app stores. These Android platforms include Huawei, OPPO, vivo, and other domestic market shares accounting for 60% of the "hardcore alliance", as well as 13% of Xiaomi.

Generally, players can download the game installation package on the official website and third-party channel platforms (app stores, Bilibili, etc.), which are commonly referred to as official servers and channel servers. The existence of channel servers can be seen as game developers delegating part of the game's operating rights to channel platforms to jointly operate the game.

Although players on different servers experience the same game content, channels may have their own operational characteristics, such as organizing operational activities different from the official server, having special recharge discount periods, and so on. However, the disadvantage of channel servers is that historical data cannot be interconnected across platforms.

For third-party channel platforms like the ones mentioned above, they have formulated different commission methods and ratios based on their advantages/positions (user base).

(1) Apple App Store and Google Play generally take a 30% commission, although they have lowered the proportion for some in-app payment scenarios (subscription payments). However, for game developers who find it relatively easy to make money, they have always maintained a 30% commission rate. Epic, which became popular with "Fortnite", has also been in a legal battle with Apple over revenue sharing in recent years.

(2) Domestic Android app stores generally take a 50% commission on the game revenue of channel servers, and only strong top players can negotiate a 30% ratio. However, this is an exception, and most game products still suffer from being "blood-sucked".

Tencent's decision to no longer release subsequent versions of DnF mobile game on Android app stores is naturally due to dissatisfaction with the high commission rates of app stores. Disputes over profit sharing between content (app developers) and channels have not been uncommon. Each confrontation reveals changes in the position of both sides in the industry chain.

Interestingly, prior to this announcement, there was another news report about the "friendly cooperation" between Huawei's HarmonyOS and Tencent - HarmonyOS does not take a commission on the revenue within WeChat, and at the same time, HarmonyOS is considering discussing lowering the channel revenue sharing ratio to 20% with game developers to attract more game developers to develop game versions compatible with HarmonyOS (currently, most developers only develop Android and iOS versions) Two pieces of news, one reflecting Tencent's strength, and the other showing Huawei's goodwill, actually both demonstrate the victorious attitude of developers facing channel distributors.

However, exactly three years ago, Tencent and Huawei had a conflict, but at that time Tencent compromised and the revenue split between the two remained at 5:5.

After three years of ups and downs, why did Tencent's attitude change so drastically? This time, by "quickly taking down" the game, will the channel make concessions? What impact will this have on game developers represented by Tencent, and even on app developers, and the Android channel?

Coincidentally, Dolphin Jun also wanted to update the changes in the game market recently, especially the impact of emerging channels on the industry. Today, let's discuss this event.

I. Parting ways after "three years," a reversal in status

Before delving into this conflict, let Dolphin Jun first remind everyone of the cause of the first conflict three years ago.

At the beginning of 2021, there were two special backgrounds for the conflict between Tencent and Huawei:

a. Firstly, it was during the one-month period when the Chinese version of "Call of Duty Mobile" was launched, and the game performed very well at that time, with first-week revenue on the iOS platform reaching TOP4.

b. Secondly, in the previous two years, the domestic mobile game industry saw a peak in buying traffic, and after the rapid deterioration of ROI, it began to reflect on the trade-off and balance between game quality and traffic.

In such an environment, as the cooperation agreement between Tencent and Huawei was about to expire and be renewed, a content giant and a channel giant, the two sides had a conflict over the revenue split ratio of "Call of Duty Mobile." Tencent wanted to adjust it to 7:3, but Huawei's bottom line was 5:5 for old games and 3:7 for new games. In other words, the focus of the conflict, "Call of Duty Mobile," would still have a 50% revenue split as before.

Both sides were unwilling to compromise on the key issue, so Huawei took the lead in announcing that all Tencent games would be removed from their platform, with a strong and tough tone. In contrast, Tencent's subsequent announcement used milder language, stating that they would actively communicate and negotiate with Huawei to restore the cooperation as soon as possible.

In the end, Tencent chose to compromise and accepted the 5:5 revenue split ratio stipulated by Huawei. Therefore, the application developer challenged the channel for the first time but unfortunately failed.

However, three years later, the same conflict between the two sides has undergone significant changes:

(1) Both focusing on the revenue split ratio, the new game "Dungeon & Fighter Mobile" had better performance than "Call of Duty Mobile," with first-week revenue on the iOS platform of DNF Mobile reaching $63 million, while "Call of Duty Mobile" on iOS had first-week revenue of $14 million.

(2) Tencent took the lead in sounding the horn of conflict. They announced the cessation of cooperation before the channel did.

(3) The channel's response was slower this time, and they only took down "Dungeon & Fighter Mobile" instead of all Tencent games like Huawei did three years ago.

All of the above <1-3> point to a clear understanding: Tencent, the content giant, has strengthened its voice towards the channel.

II. How much courage did DNF Mobile give Tencent to confront the conflict? Tencent's announcement this time can be described as a domineering "forcing the palace". In the afternoon, it was officially announced that the deadline for not putting the game back on the shelves is June 20th, leaving the channel partners only one night.

Such a "hasty" decision without room for discussion seems to be determined to cut ties with the channel partners. However, this sudden change will definitely have an impact on the DNF mobile game. Could it be because Android users are not valuable enough, so Tencent is drifting away?

Not really.

Although DnF mobile game is not a low-spending high DAU game, it does rely more on high-paying players. Generally speaking, for individual game players, iOS users have higher average spending power, and some small and medium-sized games focus only on developing the iOS version to save costs and improve ROI.

But for a big IP game like DnF mobile game, with a peak online user base exceeding 5 million on the first day and an annual revenue expectation of billions, ignoring Android users is completely impossible. According to the performance of DnF mobile game in the first week, with a total revenue exceeding 1 billion, of which 460 million is from the iOS side (DotData), it can be calculated that the Android side contributed 560 million, more than half of the total revenue.

Therefore, in response to this sudden delisting, Tencent is not without a plan. With the major update on June 20th, they are urging users to download the new version in time, while also leaving a reminder—directing Android users to download the game from the official website.

For the Android hardcore alliance, the days of earning 50% revenue share without much effort have been too comfortable. Moreover, since Tencent failed to win the fight three years ago, it is highly likely that they will not back down without a fight. Only super head games can give Tencent the courage to fight to the end. Currently, DnF mobile game, which greatly exceeds revenue expectations, is the super head game that can stir up the market.

So, how explosive is DnF mobile game?

With over 300 million revenue on the first day of launch, and due to its continuous dominance in the past month, the market's annual revenue expectation for "DnF mobile game" has quickly increased from 5-10 billion to 15-20 billion, with some institutions even optimistically estimating up to 30 billion.

Dolphin believes that the latter expectation is too optimistic with a linear extrapolation. However, the strong IP sentiment of "DNF mobile game" in the first month has overshadowed the game's action-oriented MMO revenue decay attribute, which is fundamentally different from MOBA games like "King of Glory" and "Peace Elite". Therefore, exceeding the revenue of "King of Glory" in the first month does not mean that it can maintain this level for 12 months.

The market's optimistic expectation of DnF's revenue reaching 30 billion is 7 times the first month's revenue, which directly compares DnF's sustainability with the high-quality MOBA games released in the past two years. But based on the current 7-day retention rate, DnF mobile game's 62% is already better than ordinary MMOs, but still lower than MOBA games. Therefore, based on the assumption of first-year/first-month revenue = 5 (slightly higher than the very good performance of "Moonlight Blade" in its first year), Dolphin estimates that the first-year revenue can reach 20 billion

However, it cannot be denied that even though some institutions are optimistic and overestimate the revenue, "DnF Mobile Game" is already a successful game that has leaped to the top tier. It is also a "life-saving talisman" that allows Tencent Games to finally rise again after three years of silence. Dolphin Jun predicts that with the blessing of DnF Mobile Game in the second quarter of this year (assuming a revenue of 5 billion, realizing 40% of the revenue in the quarter, totaling 2 billion), Tencent's domestic game revenue is expected to recover to a year-on-year growth of 5% (other games decline by 2%, plus the net increase of 2 billion brought by DnF), reaching a single-quarter revenue of 33.3 billion.

Similar to "DnF Mobile Game," if the original 50% commission is applied, the Android channel (assuming a revenue share of 50%) can directly achieve a net income of 3.8 to 5 billion. This directly accounts for 9% to 11% of the traditional game revenue scale of around 450 billion in platforms such as application stores (in 2023, Xiaomi's game revenue was 4.4 billion, with a terminal device active share of 10.2%, calculating the total market application store revenue scale to be around 450 billion).

If the case of "DnF Mobile Game" is replicated in other games without this fat, channels will not remain calm. Therefore, the opportunity for Tencent to reignite the battle cleverly with the explosion of DnF and the expiration of the three-year cooperation presents a greater chance of winning than three years ago.

For Tencent, the target users of "DnF Mobile Game" are very precise and easily reachable—mostly players of the DnF PC game. Third-party application stores have not expanded the user coverage for DnF Mobile Game. Therefore, Tencent's tough decision to cut off channels is a way to minimize losses and gamble on greater future profits.

Three, the two main reasons for the escalation of content and channel conflicts

Although Tencent has become the completely dominant party in this fight, Dolphin Jun believes that the final result may be resolved in another way—lower channel commissions for some top-tier games like "DNF Mobile Game."

This conclusion is not purely speculative but based on evidence. The most direct evidence is the news reported by Bloomberg on the same day—Huawei's HarmonyOS system intends to lower game commissions to 20% to attract more developers to join HarmonyOS and enrich the Harmony content ecosystem.

Although the HarmonyOS adjustment is to attract developers to join, such cooperation splits often follow the initially established plan once the situation returns to normal. Any adjustment by either party poses significant challenges unless it demands special treatment like the phenomenon of this time Therefore, Dolphin predicts boldly that after this negotiation, the channel commission ratio for high-quality games will be relaxed to at least 30%, and even the commission for super head games will be reduced to 20%. In the future, as the channel's bargaining power continues to weaken, all games will be motivated to approach a commission ratio of close to 20%.

However, on the other hand, Dolphin believes that the core contradiction between content and channels this time is different from three years ago—three years ago, it was simply a struggle for commission ratios, but now there is also the direct competition of official servers to grab users, attempting to overthrow the channel's existence.

For example, the trigger of this conflict—due to the official server assistant app (DnF Assistant) being launched before the game, promoting "pre-register for ID" to attract users to download the official server, the channel is dissatisfied with the official server's direct user grabbing actions. In addition, Tencent's backup plan in this conflict—guiding Android users to download the game from the official website, actually reflects the direct confrontation between the game's official server and the channel server.

1. Emerging user acquisition methods accelerate channel transformation

The benefits of introducing official servers have long been explored by NetEase. According to the management's statement during a conference call, in some old games, the revenue from official servers has already accounted for one-third of the total revenue, that is, iOS: third-party Android: official server = 1:1:1.

Most new games may not be able to completely abandon traditional channels such as hardware manufacturers' app stores, especially for games with a large number of DAUs, such as "Egg Party" and "Peak Speed". These new games often rely heavily on acquiring users in the early stages, so only by deploying software packages through a wider range of channels can they achieve the goal of acquiring a large number of users at the initial launch.

However, for games with a target user base in niche categories, such as "All-Star Street Basketball Party", NetEase will try to completely abandon traditional Android channels and choose a new pure buying method for user acquisition—buying traffic on Douyin, Kuaishou, and Bilibili, and then guiding users to download the official server installation package.

In addition, for perennial games with relatively fixed players, such as "Fantasy Westward Journey Mobile", they can use private domain operations/emerging channel acquisitions to guide users to download the installation package from the official website, thus avoiding the 50% commission from traditional channels.

NetEase's proactive channel transformation began to be heavily promoted around 22 years ago, bringing the company the greatest benefit in recent years, which is the continuous increase in game gross profit margin. Currently, in 1Q24, game and related value-added services have reached 69.5%. If low-margin value-added services such as live CC are excluded, the pure game gross profit margin should already be above 70%.

If Tencent also chooses this approach, assuming that guiding perennial games like "King of Glory" and "Peace Elite", which have been operated for many years and account for half of the total game revenue, to bring one-third of the revenue to the official server without channel sharing, the profit contribution from the game business will also see a significant increase: According to third-party data, the annual revenue of "Honor of Kings" is approximately around 45 billion RMB, with 40% from iOS and 60% from Android. Assuming that all current Android users come from app store channels, if half of the future Android channels switch to a zero revenue-sharing official server, it means that the gross profit of "Honor of Kings" will directly increase by over 6 billion RMB, calculated for 2023. This channel transformation for a game will directly raise Tencent's comprehensive gross profit margin by 1 percentage point. (Of course, in reality, it is not that high because Tencent has other channels besides the official server, such as WeChat games and MyApp.)

However, it is worth mentioning that the new game's attempt to acquire users through buying traffic has also led to an increase in NetEase's buying traffic expenses. Nevertheless, emerging channels that always have a net inflow of traffic (short video platforms like Douyin, Bilibili, Xiaohongshu, etc.) cannot afford to lack buying traffic on their platforms at any time. Therefore, while the comprehensive channel proportion decreases, another form of "game traffic buying trend" is making a comeback. But this time, for game developers, buying traffic does not significantly increase the burden on profitability.

2. Incremental to stock, only head-to-head competition is useful

When all under heaven is at peace, profit is the only concern. Whether it's content vs. channels, official server vs. channel server, or new channels vs. old channels, this increasingly confrontational trend stems from the gradual shift from incremental to stock market trends.

After the pandemic bonus, the global mobile gaming market has entered a period of growth bottleneck. The domestic Chinese market may be more affected by the disturbance of the suspension of game approvals, but markets outside of China have not naturally resumed growth trends. In this environment of overall contraction, the overseas stories of domestic mobile game developers, after a year of rapid progress, quickly quieted down in the second half of last year.

In 1Q24, the overseas revenue growth of domestic game developers has recovered to 5%, but this is purely contributed by Tencent's own alpha (Supercell's "Brawl Stars" contributing, with a series of measures such as introducing gacha luck gameplay to increase user stickiness and payment conversion, the average monthly revenue after the revision increased by 5 times compared to June last year).

Dolphin believes that the stagnation in the mobile gaming market is not mainly due to a weak macroeconomic and consumption environment. Historical experience shows that entertainment consumption during economic pressure periods, because it can bring players relaxation and pleasure, and release stress, the industry, especially high-quality games, are more likely to exhibit countercyclical trends.

The real reason why the mobile gaming market is quickly reaching a plateau, we believe, is not only due to the persistent supply issues in the industry - the scarcity of "high-quality" games due to the contraction of the number of game licenses, but also the significant slowdown in demand growth - with the end of the internet traffic dividend, game user penetration has reached its peak.

Since 2021, the number of game users has basically not increased. From 2020 to 2023, the annual average growth rate of online game players is only 1%, while in 2019, there was still a 2.5% growth rate in user numbers.

Howe

ver, the countercyclicality of games can be glimpsed from changes in per capita spending data. Although the average per capita spending also saw a significant decline in 2022, balancing the fluctuating effects of the epidemic and the suspension of game license approvals, looking at the CAGR from 2020 to 2023, the growth rate of per capita spending reached 5.8%, even higher than the 5.4% year-on-year growth rate in 2019.

Although we say that games have relative countercyclicality, it does not mean that per capita spending can continuously rise against the macro environment. Generally speaking, industries that rely solely on the increase in per capita spending for expansion often need the industry as a whole to undergo a disruptive experience, thereby changing the willingness of users to pay.

When the industry cannot reform and the market size cannot leap, manufacturers will start to "implode" spontaneously: modeling, special effects, and even AI NPCs. In order to meet more demands and experiences of users with limited R&D budgets, manufacturers keep cutting back on ongoing projects, but the total R&D investment only increases.

However, the more tragic reality is that under huge investments, star projects can still fail quickly. Examples include "The Legend of Shooting", "Crystal Core", "Star of Dreams" in the recent past, and "Dawn Awakening", "Diablo Immortal" further back, all of which were highly anticipated before launch, but quickly fell out of favor after going live.

But with this endless cycle, apart from further increasing the appetite of existing players to make them more picky, the overall benefits for manufacturers themselves are minimal. Big companies have perennial games, so the performance pressure of new games will be less At worst, even focusing on polishing these evergreen games to further extend their product lifecycle can help them survive in difficult times.

However, for small and medium-sized companies that do not have advantages in R&D, promotion, and operations, and do not have evergreen games, the most ROI-oriented approach may be to broaden the product category track and seek new player penetration. Simply sticking to old-fashioned gameplay and product categories to promote new products will only lead to more losses.

In this development trend, the industry share will tend to be more concentrated towards the leading companies, with more and more games that can stably remain in the TOP10 having the shadow of Tencent behind them. Top games also have a stronger backbone and strive for lower revenue shares through channels, further enhancing game ROI.

However, when even the leading companies start to encounter growth issues, facing the dual pressure of slowing overseas growth in the front and high rigid investment under domestic competition, game companies can only turn back to seize a share from traditional channels. In recent years, emerging channel platforms such as Douyin, Kuaishou, Bilibili, and Xiaohongshu have developed rapidly, completely overshadowing traditional marketing models with the overwhelming display volume of short video information flow and the power of content marketing.

As the coverage of short video users becomes wider and the overlap with game users increases, even former rivals like Douyin and Tencent are sitting at the same table, questioning why traditional channels that only know how to take a cut can still comfortably feed on developers?

After going through three years of cyclical disturbances, this summer's game market is rare with various outstanding performances, as both large and small companies have brought out their best in the summer golden period. Judging from the current Waterloo of "The Legend of the Condor Heroes" and the better-than-expected performance of "DNF Mobile" and "Three Kingdoms: Strategy to Rule the World", the summer battlefield will be intense and brutal.

With the trend of limited licenses and the concentration of revenue towards high-quality products, the strategic effectiveness of the previous product matrix (focused on quantity) may become more challenging. Therefore, for investors in game companies, the assessment of the quality of individual game products and the expected revenue after launch will be more crucial.

Who will stand out and win the fierce battle of the summer? How to evaluate the game recovery of Tencent and Bilibili? Can NetEase, the second player, recover from the failure of "The Legend of the Condor Heroes" and the disruption of the evergreen game "Fantasy"? Will the product cycle of the "Pig Factory" continue smoothly? Why does "Muffin" have such strong sustainability, and can TapTap ride another wave of channel transformation dividends?

In the next article, Dolphin will focus on individual stocks to further discuss the above issues, while updating the future expectations and valuations of Tencent, NetEase, Bilibili, and Xindong, among other companies, in the gaming business Risk Disclosure and Disclaimer for this article: Dolphin Research Disclaimer and General Disclosure