Looking positively ahead, but still controlling costs (Tencent 1Q23 earnings call transcript)

Below is the summary of the Q1 2023 earnings call for Tencent ($TENCENT.HK), for financial analysis please refer to "No surprises from Tencent? The golden quality of the stock king cannot be hidden"

I. Q1 2023 Financial Highlights

1. Revenue: RMB 150 billion, YoY +10.7%, beating market expectations (2.51% beat).

2. Profit: Net profit of RMB 32.5 billion, YoY +27.4%, lower than market expectations (-2.13% miss).

II. Management Remarks

1. Overall Review

In Q1 2023, Tencent achieved double-digit revenue growth, with payment services driving domestic consumption recovery and benefiting from increased payment amounts. Gaming revenue improved, and advertising revenue maintained rapid growth. Non-GAAP net profit achieved higher growth on a low base in the same period last year, reflecting the improvement of revenue structure and operational efficiency. The company is investing heavily in building artificial intelligence capabilities and cloud infrastructure to embrace the opportunities brought by basic models. We believe that artificial intelligence will become a multiplier for business development, enabling the company to better serve users, customers, and society as a whole.

2. Strategic and Business Review

In Q1 2023, total revenue increased by 11% YoY. Among them, VAS accounted for 53% of total revenue, with social networks accounting for 21%, domestic games accounting for 23%, and international games accounting for 9%; online advertising accounted for 14% of total revenue; and fintech and enterprise services accounted for 32% of total revenue.

1. Value-Added Services

VAS revenue was RMB 79.3 billion, up 9% YoY. Social network revenue increased by 6% YoY to RMB 31 billion, mainly driven by the sales of virtual props in games and music subscription services.

However, the company has taken measures to address this issue, including: (1) enhancing the company's content to meet the ever-changing needs of users. In April, the company launched its self-produced drama "The Long Season", which became the highest-rated domestic TV drama on Douban in the past five years; (2) the company is expanding its cooperation with short video services to enhance the popularity of its long video content and seize more commercial opportunities.

- In terms of music, the company upgraded the listening experience, strengthened cooperation with record companies and artists, thereby increasing user stickiness and willingness to pay, and music subscription revenue increased by 30% YoY.

• Domestic game revenue increased by 6% YoY to RMB 35.1 billion. Core products such as "King of Glory", "DNF", and "CrossFire Mobile" performed well. The new game "Dark Zone Breakout" released by the company in the third quarter of last year also made a significant contribution to the growth. International game revenue increased by 25% YoY, with a fixed exchange rate growth of 18%, reaching RMB 13.2 billion, mainly driven by the strong performance of recently released games such as "Goddess of Victory: Niji" and "Triple Match 3D", as well as the steady growth of "VALORANT".

2. Communication and Social Networking

• On the WeChat side, the usage of Video Accounts continues to grow, with both user usage time and playback volume rapidly increasing. In order to promote its continuous organic growth, the company is cultivating a healthy and active creator community: first, the company has upgraded its support for new creators, providing more traffic incentives, wider coverage of creators, and more effective content creation tools; second, the company has strengthened the infrastructure for e-commerce, helping creators benefit from sales commissions related to e-commerce transactions, such as enriching customer management functions and the Video Account store, making it easier for creators to interact with customers and improve sales conversion rates.

• On the QQ side, the company has adopted a new technical architecture to optimize cross-platform development efficiency on a unified codebase, and this new technical architecture also enhances user security and improves visual experience by strengthening data encryption mechanisms. The new technical architecture will significantly strengthen QQ's future cross-platform product deployment.

3. Local Market Games

The company continues to implement its minor protection plan. In 1Q, the game time and revenue of minors accounted for only 0.4% and 0.7% of the total game time and revenue of the company's local market games, respectively, a decrease of 96% and 90% compared to the same period three years ago.

During the Spring Festival, "King of Glory" launched a skin series and a precise marketing plan with the theme of "Classic Chinese Mythology", and 1Q revenue reached a historical high. The PC game "CrossFire", which the company began operating in 2008, launched a promotion campaign for Internet cafes, successfully attracting returning players. The mobile game "CrossFire Mobile", released by the company in 2015, launched a theme content based on a virtual idol group customized for the game, which was well received by players. The revenue of "CrossFire" PC and mobile games in 1Q both reached historical highs.

The high-potential game categories released by the company in recent years have also achieved new milestones. The auto chess game "Jin Chan Chan Battle", released by the company in 2021, achieved a YoY revenue growth of over 30% in 1Q. The company launched a faster-paced game mode, attracting new and old players, and the daily active account number exceeded 10 million in April this year, reaching a historical high.

The first-person tactical shooting game "Dark Zone Breakout", released by the company in July 2022, has also cultivated a highly engaged user group and strengthened marketing activities during the Spring Festival. In 1Q, the DAU and revenue of this game both reached historical highs. In addition, the company released "Metal Slug: Awakening" in April, transferring the classic arcade game IP to mobile and multiplayer gaming experiences, ranking first among new action games released this year.4. International Market Games

Total revenue increased by double digits, with outstanding performance from key games. "VALORANT" achieved year-on-year growth in monthly active accounts by launching new maps and heroes. Japanese-style and alien-themed weapon props were popular, driving game revenue to grow by more than 30% year-on-year in 1Q 2023. "PUBG Mobile" benefited from new combat features and upgrades to player-versus-player gameplay, with daily active accounts recovering month-on-month. The company launched a game map editor to help players develop game content, improving player stickiness and extending the game's lifecycle.

Subsidiary Miniclip released "Triple Match 3D" in April 2022, achieving breakthrough success in the fiercely competitive consumer category. Thanks to its creative gameplay and efficient promotion, "Triple Match 3D" became the only game released in the past two years to rank in the top ten of its kind and drove Miniclip's total revenue to a historic high this quarter.

5. Online Advertising

1Q revenue was RMB 21 billion, a year-on-year increase of 17%.

However, due to off-season factors, revenue decreased by 15% month-on-month. Thanks to the recovery of Chinese consumption, advertising spending in most industries increased year-on-year. For example, businesses increased spending to capture the growth of retail sales; due to the rebound of offline activities, large e-commerce platforms gradually recognized the company's services as a key user acquisition channel, thereby increasing advertising spending here. The company upgraded its machine learning platform for advertising, integrating its deep learning models and standardized product library to provide better advertising targeting capabilities and higher conversion rates for advertisers.

• WeChat's advertising growth rate exceeded the overall advertising business growth rate and contributed more than half of the company's total advertising revenue. Video accounts attracted new advertisers and increased budgets from existing advertisers, driving a significant increase in video account advertising revenue. The average eCPM of video accounts is higher than that of other short video platforms, reflecting advertisers' recognition of the company's ability to convert video account views in WeChat to transactions in mini-programs.

• In terms of content platforms, the growth of music advertising revenue was mainly driven by the growth of ad-supported music content, and the company's music advertising revenue grew rapidly year-on-year. Due to the decrease in the release of popular content, the company's long video advertising revenue decreased year-on-year.

• In terms of mobile advertising alliances, its year-on-year growth was strong. On the supply side, the company increased high-conversion-rate advertising inventory, such as smartphone manufacturers' applications. On the demand side, the company attracted more advertisers who focus on advertising efficiency, such as e-commerce platforms.

6. Financial Technology and Enterprise Services

Revenue from financial technology and enterprise services grew by 14% year-on-year to RMB 48.7 billion. Thanks to the recovery of payment activities, financial technology service revenue achieved double-digit year-on-year growth. At the same time, revenue from wealth management and consumer loans continued to grow at a healthy level year-on-year.

• Thanks to the stable cloud services after a period of large-scale restructuring, as well as the reduction of loss-making projects and cost optimization, and the monetization of live e-commerce, the gross profit margin and gross profit of enterprise services have increased significantly year-on-year.

• In terms of cloud services, the company's smart transportation solutions have helped the digital upgrade of large-scale transportation projects. For example, the company uses its professional capabilities in cloud infrastructure, digital maps, and 3D rendering technology to serve Sichuan Province's smart highways and Guangzhou's subway projects.

Q&A

Q: What changes have occurred in user behavior, consumption frequency, and willingness in the gaming business? How does it compare to before the epidemic? Is the growth of the gaming business due to effective marketing or industry factors as a whole?

A: The company's most successful games, including "King of Glory," "League of Legends," "CrossFire" mobile games, "Peace Elite," and "PUBG" mobile versions, are usually based on team-based competitive games that are designed fairly and can be played for many years.

The main reason for the good performance of 1Q is that the company has released more attractive content, and players have invested time and money in it, which ultimately translates into revenue and drives the company's revenue growth. For marketing activities, the company is becoming increasingly adept at launching appropriate skins at specific times, such as launching specific products during the Lunar New Year or May Day holidays. This will be a continuing trend rather than a quarterly phenomenon.

Regarding changes in user behavior from the epidemic to today, the company has not seen significant changes, but overall, after three years of the epidemic, although the economic situation is still mixed, the overall purchasing power has increased, especially for perennial head games and other content-driven games, and the company is also consolidating its position.

Q: How does the management view the recent industry price cuts? How will this affect Tencent's existing plans and industry structure?

A: In terms of enterprise services, especially cloud computing price cuts, the impact on Tencent is not significant. Even at the IaaS level, industry price cuts only apply to long-term prepaid contracts, which are generally signed by small and medium-sized enterprises, not large enterprises.

Cloud services are an industry where server and bandwidth costs generally decrease over time, so it is reasonable for industry participants to translate these cost reductions into price reductions for their customers. For the company now, it is more important to continue to double down on its competitive advantage in cloud computing, continue to provide the best service to customers, and price is one aspect, but not the only aspect.

Q: Why did deferred revenue in the balance sheet increase by 18% this quarter? Can we expect strong revenue performance from VAS and games in the next few quarters?

A: In fact, deferred revenue has many components, including virtual game projects, business cooperation agreements, and other prepaid projects.

For BCA business cooperation agreements, it is natural for them to decrease month-on-month because they are charged and amortized based on the original contract, while the decrease in prepaid advertising is due to seasonality and BCA amortization.Q: Recently, the company selectively launched installment payment products for paid users. When will this product be launched to other paid users? What is the impact on the financial technology business?

A: The installment loan product is linked to consumption and actually allows users to choose to pay for high-priced products in installments. At the same time, the company's design is based on some principles: (1) compliance with regulatory requirements; (2) user demand. Therefore, the focus of the product design is to create user value. When users want to purchase goods and this is a clear consumption demand, if they have enough credit on the company's platform, the company allows them to pay in installments for a long time. In some cases, merchants also hope to see installment payment behavior occur.

In terms of risk management, the company is very focused on the risk management of this product, so it is being piloted and tested. First, it is necessary to understand credit performance before gradually launching the product. With the passage of time, it is hoped to cooperate with licensed financial institutions to expand the product.

In summary, this is consistent with the trend of expanding the scope of value-added financial services; the factors just mentioned and self-restraint in overall scale growth are important risk control mechanisms.

The direction of future financial product management: strict risk control + high-quality service improvement.

Q: In terms of macro environment and advertising business, it has been two quarters since the epidemic prevention and control was lifted. With the increase in revenue contribution from Video Number, how should the company view the CAGR of advertising business revenue in the past two years? With the gradual recovery of industries such as e-commerce, will the company see further improvement in the growth rate of advertising business in the remaining time of 2023?

A: Regarding the advertising business, China is currently experiencing widespread consumption recovery and growth, although the recovery speed of various vertical fields is not uniform. However, relatively speaking, the recovery of everyday low-ticket price items is more obvious, while the recovery speed of high ticket-price items is fast or slow, and there is differentiation. As for how the recovery of consumption can be transformed into the company's advertising revenue, currently, the performance of related industries is very strong, and there are no vertical industries that are performing very weakly. However, the company can see that these companies are very keen to promote their sales, and one of the ways to promote sales is to advertise on the company's platform.

As of 1Q23, the CAGR of advertising business in the past two years was -2%; for the outlook of advertising business afterwards, although no guidance was given, logically speaking, the advertising business will see further improvement in the remaining time of 2023.

It should be noted that in 2021, the company's largest advertising category at the time-education, experienced a sharp decline in advertising spending. Also in 2021, the company lost several important advertising forms, such as splash screen advertising. Therefore, for the company and the entire industry, compared with the low base in 2021, the development of advertising this year will be relatively easy. It is believed that with the company's continued development in the next few months, the situation of advertising business will become better.Q: Management's view on AI basic models. What is the commercial value of such basic models for the company's business? What is the company's view on relevant regulatory policies, industry competition, and the availability of infrastructure and chips? How does the company view the role of AI basic models in driving cloud computing business in the second half of this year and next year?

A: [1] Basic models

It is believed that with the development of AI technology, many basic models will appear in the future market, and every big company like Tencent will have its own basic model. Tencent's basic model will not only support its own business scenarios, but also provide services to B-end and C-end users. At the same time, many start-ups will establish their own AI models, some of which may be general models, while others may be specific models for vertical industries, bringing a wide range of application scenarios.

Overall, the interaction between users and machines, especially in the application areas related to search and information generation, will be more disruptive, and there will be more disruptive applications in the fields of search and content aggregation. As for the interaction between users, such as social networks, short videos, games, and long videos, generative AI will help improve the quality of content and the efficiency of content creation, and reduce the cost of content creation. These fields will be the beneficiaries of generative AI technology.

[2] Regulation

In terms of regulatory policies, the government's overall stance on the AI industry is supportive, but this industry must be regulated; this is not unique to China, but a common practice worldwide. For example, there are many public discussions about AI regulation in the United States, and even one of the founders of OpenAI has been calling for regulation in this industry. Therefore, the company believes that regulation is necessary. At the same time, under the correct regulatory framework, the government also supports innovation, and the industry will have a healthier development space.

[3] Chips

In terms of chips, at the current point in time, chips are available, and some GPUs that are restricted can also be sold in China through alternative methods. Now all companies are trying to get more chips, and there may be a shortage of chips.

However, as time goes on, the problem of chip availability will be solved, and other players who want to build basic models will be able to obtain chips to build their basic models.

Q: This quarter, benefiting from the monetization of Video Account, operating leverage, and cost optimization, the profit growth rate far exceeded the revenue growth rate. How do you view the change in this gap in the next two quarters?

A: The gap between revenue growth and non-IFRS net profit growth is exceptionally large on a year-on-year basis, but the compound growth rate of revenue growth and operating profit over the past two years is basically the same. I believe that the gap between the two will be between the above two numbers in the future. The reason for the large gap this quarter is mainly because:

(1) The non-IFRS profit base in the same period last year was very low, and the company expects this gap to narrow as normalization occurs.(2) Compared with the past, this will help improve the profit margin. Many new sources of revenue for the company, such as this positive profit combination transformation, are important factors for the company.

Therefore, overall, I believe the company can expect profit growth to be consistent with or faster than revenue. However, due to the base effect and some other factors mentioned by the company, the gap between profit growth and revenue growth in 1Q is unusually large.

Q: The effective tax rate this quarter is quite high, mainly driven by a one-time deferred tax payment from overseas subsidiaries, but the company does not seem to have adjusted for this one-time impact on non-GAAP net income. How do you view this adjustment to adjusted net income?

A: The adjustment for deferred tax payments is not within the scope of adjustments under international financial reporting standards. The company usually looks at the effective tax rate on an annual basis rather than a quarterly basis because there are occasional miscellaneous adjustments, such as some withholding tax.

Q: What progress has Mixun AI made in product landing? Can you share more progress on potential product releases? Does the company's training data include open data within the company? What impact does it have on interoperability?

A: Significant progress has been made in the infrastructure sector, especially in the Mixun model, and the development of model construction has also shown a clear and positive trend.

(1) In terms of data, the company's data coverage includes the entire Internet, and specifically adds domestic data. As far as Chinese data is concerned, it includes high-quality public data as well as rich data in the company's content ecosystem. The company has a large amount of unique internal content, which provides a quite unique supplement to the entire data.

(2) In terms of model training, the company is expanding the training scale, and infrastructure is the company's core advantage. In addition, as mentioned earlier, the company recently announced a high-performance computing cluster based on Nvidia H800 GPU, which will bring additional efficiency to the company in training. One of the core advantages of the company is the use of scenarios, and different teams of the company are planning some interesting products.

In summary, the company has made good progress. The company firmly believes that artificial intelligence will show exponential growth in the industry, especially for Tencent. The company's core user services have not been affected and can benefit from it, as this can actually help Tencent produce attractive content on a large scale at lower costs, all of which help improve service quality, improve monetization capabilities, and reduce costs.

In addition, the basic model also helps the company introduce machine services, which provides a new perspective for improving search in both WeChat and browsers. In the future, the company may launch some interesting digital assistants in its services. Cloud computing is also very important, and the company believes that over time, large models can provide very attractive services for the company's enterprise customers in the cloud, further enhancing the company's PaaS and SaaS competitiveness.

Q: What are the latest regulatory dynamics in the domestic gaming, short video, and fintech sectors? The domestic gaming industry made significant progress in the last quarter, with relaxed regulatory environment and new content releases in the market. Can we expect the growth of this business line to accelerate and possibly return to double-digit growth?A: [1]

The regulatory environment is gradually becoming normalized, and the government is also very concerned about the development of the economy and the healthy development of the digital economy and industry. At the Central Political Bureau meeting on April 28th, it was called for the promotion of orderly and healthy development of platform companies and encouragement of platform companies' innovation.

(1) In terms of domestic games, the new normalized regulatory status will continue to be maintained, and the game version number is expected to be approved regularly. This is also part of the reason why the company has seen considerable growth in the Chinese game industry.

(2) In terms of short videos, there are not many regulatory updates, and it is not currently the focus of regulatory action.

(3) In terms of financial technology, it is beginning to move towards normalized regulation.

Looking back at 2021, the People's Bank of China required platform companies to conduct self-assessments of financial technology services and conducted a review of Tencent. During this process, the company has been actively cooperating and has proactively adjusted its operations in accordance with the requirements of the People's Bank of China. The inspection is now nearing completion, and the inspection results are being finalized. When these results are determined and released, the company believes that regulatory agencies will normalize regulation and invest more resources to support industry development and innovation.

[2] Games

Global game revenue achieved double-digit growth year-on-year in the previous quarter. The company believes that the global game industry has experienced some transitional challenges, including discomfort in Western countries after the epidemic, and China's lack of new game version numbers.

The company's performance compared to the overall industry largely depends on the quality of the content provided.

Overall, over time, through (1) operating the largest, best, and most sustainable games, (2) owning some of the most successful and creative game studios, and (3) operating high-growth game platforms (such as emerging small game platforms), the company has been able to surpass the high single-digit growth rate of the global game industry. For these reasons, the company believes that everything is worth striving for, and the global game industry is returning to a growth trajectory. The company will strive to achieve synchronous or faster growth with the global industry.

Q: In terms of overseas mergers and acquisitions, the company's international gaming business performance in 1Q23 was very strong. What is the latest progress on mergers and acquisitions, and how does management view the competitive landscape? How do you view the growth in this area this year?

A: The competitive landscape for overseas game company acquisitions has been relatively stable in the past few years.

Although many companies have active acquisition actions, their goals often do not overlap with the company's goals. They are either companies that have a large game console user group and are trying to enhance the user group by acquiring game studios, or companies that value short-term profits and try to integrate other revenue. Tencent is not limited to any single hardware device.

Therefore, the company has been acquiring mobile game studios and will also regularly acquire PC game studios, and in some cases, actively acquire game studios for game consoles.

In addition, when making investments and acquisitions, the development of the next 3-7 years is usually considered. Typically, the companies considered are those that have released a successful niche game in the previous year and whose revenue will decline in the next few years due to the digestion of the first successful game, and are expected to lose money for a period of time.Currently expanding the team size for the development of larger-scale sequels, but has not yet received revenue from them. This is in line with Tencent's strategy, but may not apply to every company. Therefore, some studios naturally gravitate towards the company, while others may choose other directions.

The pattern of acquisitions in the gaming industry depends to a certain extent on whether specific large-scale transactions are completed. We will see more changes in the future and actively respond and adapt to these changes.

Q: The management team mentioned before that WeChat contributes more than half of the total advertising revenue. Can the management provide a detailed breakdown of the revenue contribution of application products, such as Moments and Video Accounts? How to consider the revenue composition and gross profit margin trend of these products?

A: The revenue situation of each product cannot be specifically explained, but there has been a very obvious rebound in the past 6-9 months.

In terms of profit margin, all self-operated advertisements except for long videos are high gross margin, while the gross profit margin of long videos and advertising alliances is relatively lower.

Q: Domestic games achieved strong revenue growth in 1Q23, but when more new games are released in the second quarter and the second half of the year, how will the trend of domestic game business revenue growth be in the future? Will it accelerate?

A: No guidance is provided on changes in revenue growth rate.

The strong performance in 1Q23 was due to evergreen games.

In addition, games released in the past 1-2 years have shown healthy growth. Usually, the revenue brought by newly released games in the quarter of release is relatively small, and these revenues will not be reflected in the profit and loss statement due to deferred policies. However, in the following quarters, if the game performs well, deferred revenue begins to be recognized as revenue, and the monetization ability of the game will also increase, and the number of daily active users will increase.

Several recent games have performed similarly to this: (1) "Arena Breakout", the leading shooting game in China, the company has observed good growth in related monetization as players become more familiar with the game; (2) "Golden Spatula" Users and monetization growth is strong, and the daily active users of the game have exceeded 10 million in 2 years; (3) "League of Legends Wild Rift" also showed a good trend in 1Q. In the next year, the company plans to release large-scale games, some of which may have good monetization ability from the first day, while the monetization ability of other games will gradually increase.

Q: The operating cash flow in 1Q23 was strong (62.3 billion yuan), but the investment cash flow was 65 billion yuan. What is the explanation?

A: Regarding the net cash flow used in investment activities, this involves some normal project increases. Of the 65 billion yuan, 50 billion yuan is related to net time deposits. In addition, other projects such as capital expenditures, media content, and mergers and acquisitions are each around 4+.Q: E-commerce advertising growth is strong. Has the company taken away market share from other advertising companies?

A: For large e-commerce companies that use Tencent for advertising promotion, they will definitely gain market share growth. There are many reasons for this growth:

1. More complex AI machine learning technology has been added to advertising, which is particularly advantageous for large e-commerce companies with a large number of SKUs, as AI can extract SKUs and deliver appropriate SKUs to the right users in e-commerce advertising.

Q: How do you view e-commerce business, especially the development of video accounts? 1Q has begun to deduct some of the technical service fees from the live e-commerce of video accounts. Can the company obtain more e-commerce-related monetization growth in the future?

A: There is a great opportunity for e-commerce live streaming on video accounts. Other short video companies have already proven this, as short videos can drive live streaming, and live streaming can drive e-commerce transactions.

In addition, the company can provide some unique value-added points to merchants. However, we hope to gradually establish a good infrastructure and achieve the optimal balance between user experience and merchant return on investment. The most important thing is to ensure that the transaction ecosystem is of high quality. If a large number of users buy low-quality products or some high-profit products for merchants at one time, they will basically spend all their money on advertising rather than product quality, which is not conducive to the overall ecosystem. Therefore, we hope to ensure a good ecosystem, so that we can deliver the correct value to users and merchants, and maintain the healthy operation of the entire system. This takes some time, but if all of these can be done well, there will be great development prospects in this part of the business.

Q: Regarding operating expenses, the company controls OPEX very well. When will the company turn to growth spending (whether it is on new games or AI and other services)? Or does the company think that the current economic consumption recovery situation is not enough to support the company to invest more funds?

A: Regarding operating expenses, the company needs to actively invest in new game releases, large model development, and GPU purchases.

As for when to turn to investment growth, the company has many emerging growth drivers, including , which all have important opportunities and great development space over time. However, the company does not need to spend a lot of extra money to make them more popular, will not provide huge subsidies like community group buying, and is not inducing users from other short video platforms to come to video accounts. Instead, it provides users with attractive and unique experiences on a larger WeChat platform. Over time, users will discover and enjoy these contents and spend more time on them. Therefore, we do not believe that the company is in a non-growth mode. At some point in the future, the company will also invest in marketing or subsidies to return to growth mode. The company is currently in a growth mode, but the nature of the company's growth is not driven by a large number of subsidies or marketing activities.

Q: The company previously mentioned that macro factors affect players' willingness to play games and ARPU. Has the game business recovery seen by 1Q been due to a recovery in demand, and is this trend sustainable?

**Q: **What is the recovery situation of different types of gaming businesses, such as high DAU and high ARPU games?

**A: **The overall recovery of gaming business - among the top 15 games, 12 of them have seen year-on-year growth. It is not the case that only 1-2 games are recovering while others remain weak, but rather the overall performance of the game product portfolio has improved.

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