TENCENT Q2 Conference Call: E-commerce Empowers Douyin's Advertising Revenue, Exclusive Infrastructure Large-scale Model May Upgrade in the Second Half of This Year

After the Hong Kong stock market closed on Wednesday, August 16th, TENCENT released its financial performance report for the second quarter of the 2023 fiscal year. TME-SWQ2 achieved a revenue of 149.2 billion yuan, which fell short of the market's expectation of 152.021 billion yuan, with a year-on-year growth of 11% but a month-on-month decline of 1%. The adjusted net profit reached 37.55 billion yuan, representing a year-on-year increase of 33%.

Specifically, there were several highlights in this financial report for TME-SW, as mentioned in the TME-SW report. Advertising revenue exceeded 25.003 billion yuan, surpassing expectations with a year-on-year growth of 34%, driven by WeChat Video Accounts, which contributed 3 billion yuan (12% of the total). Overseas gaming revenue continued to contribute to the overall growth, while financial technology services achieved double-digit year-on-year growth. R&D investment for the quarter amounted to 16 billion yuan.

Following the release of the financial report, TME-SW's Chairman and CEO, Ma Huateng, and Executive Director, Liu Chiping, attended a conference call to interpret the report and answer questions from analysts.

During the call, Liu Chiping pointed out that the number of monthly active accounts for mini-programs exceeded 1.1 billion, with significant contributions from casual games, which attracted over 400 million monthly active users and 300,000 game developers.

Both well-known game companies and small studios are actively developing and operating mini-games based on TME-SW's mini-program framework, including casual games and card games, among others. In the second quarter alone, over 100 mini-games generated revenue exceeding 10 million yuan.

Liu Chiping emphasized that mini-games have significant strategic value for TME-SW. Firstly, through mini-games, TME-SW has built the largest casual gaming community in China, with monthly active users surpassing any individual gaming app in the market. Secondly, mini-games allow TME-SW to expand its user base and attract new players, providing high-profit margins and revenue from game distribution and advertising under the platform business model.

TME-SW expects domestic gaming revenue to rebound in the third quarter.

TME-SW emphasized that they are taking multiple measures to bring new growth opportunities to various business sectors. The first measure is to establish their proprietary large-scale model, which has already begun internal testing in different scenarios and will be upgraded in the second half of this year. They will also make more efforts in cloud services.

Q1: After experiencing strong growth in the second quarter, how do we view the macro prospects for advertising revenue growth in the second half of the year?

In recent weeks, we have continued to see double-digit year-on-year growth in all categories of advertising except for automobiles.

I believe that the growth rate of advertising revenue is obviously influenced by domestic consumption trends to some extent. However, it is worth noting that the domestic consumption trend in the second quarter was not optimistic, yet we still achieved a year-on-year growth of 34% in advertising revenue.

Looking ahead to the second half of this year, we believe that with the drive of technological improvements and monetization of video accounts, we have the opportunity to continue leading the industry in advertising growth rate. If domestic consumption remains weak in the second half of this year, advertisers' natural response will be to withdraw from investments with lower returns. We believe that the improvements we have made to the advertising technology platform using the large-scale model have significantly increased the return on investment for advertising. Q2: Besides the business aspect, I would like to hear more about the AI empowerment of the TME-SW ecosystem. How will AI help TME-SW monetize in the future?

The rapid development of artificial intelligence is indeed something that excites us more and more. It will become an increment in many of our businesses, helping to improve our work efficiency and provide users with more high-quality information. At the same time, AI can also promote our continuous progress, including in target data positioning and providing us with more low-cost and efficient production.

Regarding the development of AI, TME-SW is taking multiple measures. The first is to establish our own proprietary large-scale model, which is currently progressing very smoothly. Model training is on track, and we have started testing the proprietary base model in different internal use cases, including TME-SW Cloud, Finance, Technology, and Gaming departments, allowing them to start testing the model and making improvements in model performance. There will be upgrades in the second half of this year.

In the second half of this year, we will also make more efforts in cloud business and help enterprises deploy open-source models efficiently through the TME-SW Cloud "Maas" solution.

We see the advantages of AI in efficiency, quality, target orientation, and content production. Our subsidiary companies have also applied AI models in products to improve efficiency and competitiveness.

TME-SW Conference has deployed a model developed by one of our investment companies. During the conference, the content is recorded, and by simply opening it, AI assistants can selectively view the speeches of members and interact with them.

We are embracing artificial intelligence in many aspects, and in the medium to long term, this is very beneficial to our business growth.

Q3: I understand that there are not many new games in Q2, and the domestic game revenue is lower than expected. But apart from new games, considering the revenue of our traditional advantage games in Q2, how should we view the lifespan of games and potential future growth? How should we view the sustainability of profit margins in the future?

The gross profit margin is structural, and we believe that the higher-than-expected gross profit margin in TME-SW Q2 is due to structural changes. One of the changes is the rapid growth of WeChat mini-games. The gross profit of WeChat mini-games is much higher than that of traditional gaming business. Another factor that has recently affected us is the decrease in our live streaming revenue. We believe that the higher level of value-added service gross profit margin is sustainable in the gaming sector.

The main reason for the flat QoQ domestic game revenue in the second quarter is not the lack of new games. Although we did not launch many mobile games, we launched some PC games. Even if we have built PC game brands for ourselves, they will start contributing revenue in the second half of this year, rather than in the second quarter.

At the same time, in the first quarter, we released a significant amount of commercial content for our traditional advantage games, which significantly increased our total game revenue. However, in the second quarter, we entered a pause period and plan to resume the release of commercial content in the third quarter. We hope that games like "Battle of Gold Shovel" can have a long-lasting appeal. We have years of experience in operating evergreen games. Good games can remain popular and enduring. This is also the goal we hope to achieve with the new team now. Another point I would like to make is that I believe our game revenue does not fully reflect our development in the gaming industry. The games developed through our WeChat Mini Program platform do not showcase the rapid growth of our casual gaming sector. The Mini Games platform is currently the largest mini casual gaming platform in China. I believe it has experienced fast growth in terms of user numbers and total revenue. However, these economic benefits are not reflected in game revenue, but rather in commissions, which do not account for the entire total revenue.

Q4: Regarding advertising, we have noticed that we have taken many initiatives recently. In the short term, there is still uncertainty in the macro economy. How can we seize more opportunities to increase advertising revenue and drive growth?

I believe we are currently in a tremendous opportunity where many long-term and more direct opportunities are emerging, such as video account numbers. Advertising currently only covers a small portion of operations. Looking ahead, we will gradually increase the proportion of advertising in WeChat video accounts and convert it into more revenue.

In addition, about half of our peers' advertising revenue comes from local advertising or e-commerce collaborations in their short video services. Therefore, as we develop e-commerce in video accounts and leverage our existing infrastructure such as Mini Programs, we are in a good position to double our advertising revenue.

Q5: In terms of deploying large-scale models, in addition to the public services mentioned earlier, you hope that medium-sized and small-scale enterprises can also benefit from them and deploy services. How should the TME-SW large-scale model serve these enterprises?

The traditional challenge we face is that we have many different platforms and different types of databases. Our user base is very large, and the amount of data is also very large, making it very complex to target customers based on this data. Therefore, TME-SW Cloud has released its own vector database.

In terms of applicability, the TME-SW Cloud vector database has made significant improvements and provides services to the outside world in a more automated and intelligent manner. It now provides a powerful driving force for our targeting capabilities and return on investment through advertising. And this is still only the early stage of deployment. We will continue to improve the technology.

In the training and use of large-scale models, it requires a lot of support from heterogeneous computing power, and it also has high requirements for network speed and stability. In addition, GPU servers are less stable than general servers, so server maintenance and problem troubleshooting are more frequent, resulting in higher overall operational difficulty and workload.

To address this, we have built a new generation of High-Performance Computing Cluster (HCC) specifically for model training. It is equipped with the latest generation of GPUs, combined with multi-layer accelerated high-performance storage systems, and high-bandwidth, low-latency network transmission. The overall performance has been improved threefold compared to the past.

Therefore, from CPU to GPU, we have built a very powerful neural network that can basically handle all these different complexities and provide optimal solutions. Q6: What are the plans for future game releases? How is the scale of WeChat live-streaming e-commerce?

Regarding games, we have many new games, both domestic and international, that will be released in the coming months.

In terms of e-commerce, there have been many commercial activities on our mini-program before the launch of video accounts and live-streaming e-commerce. The GMV level of these e-commerce activities is over trillions. As for live-streaming e-commerce, it is a new form of e-commerce that generates revenue at the level of billions.

WeChat's e-commerce, especially live-streaming e-commerce, has actually helped many businesses acquire new customers. E-commerce activities on WeChat mini-program essentially allow businesses to serve their existing customers through their own channels and attempt to drive repeat purchases from existing customers. In live-streaming e-commerce activities, businesses now utilize these platforms to promote their products and services to new customers. Over time, it complements mini-program e-commerce activities as well. Live-streaming e-commerce activities are a great addition to the entire ecosystem. It actually brings us more revenue as it generates commission income. Additionally, it generates more advertising revenue within video accounts.

Q7: Can you provide an update on the recent developments in domestic games, short videos, and regulatory measures? Furthermore, the government has issued new regulations to protect minors' internet usage. Could you introduce to us the potential impact of these new regulations on your business and the risks to your revenue?

We have been discussing industry regulations, and in the previous conference calls, we mentioned that regulations have been moving towards normalization. What I want to say is that this time, in addition to normalization, there is actually a more supportive stance. Firstly, regulatory authorities have repeatedly emphasized the prominent role of the private sector and the platform economy, reaffirming their commitment to promoting the healthy and sustainable development of platform companies. Financial regulatory agencies have basically stated in early July that they have concluded their disciplinary actions against the fintech industry and will focus on regulatory normalization in the future, supporting and encouraging the platform economy to continue its efforts in financial inclusion.

On July 12th, the National Development and Reform Commission issued a statement recognizing the contributions of internet platforms and startups to technology and innovation, with TME-SW being specifically mentioned. In the gaming sector, we see continued normalization of regulations. Therefore, in all these different sub-markets where we have significant business, we have seen the regulatory environment trending towards normalization and providing more support to market participants.

Regarding regulatory measures for the protection of minors, we fully support and accept this policy because it is something we have already been doing in many different products. For example, in the games we have implemented, the measures for pre-protection are actually stricter than the requirements of the policy.

Q8: How should we view the profit growth trend for the second half of this year and even 2024?

Our profit growth benefits from three factors:

Firstly, the transformation towards a business structure with higher-profit revenue, which includes not only video accounts but also an overall improvement in profit across many games. Secondly, we have reduced certain low-profit margin revenue sources, including some resale businesses in cloud services and live entertainment heavily focused on TME-SW music. Thirdly, we now have a different culture that places great emphasis on cost, discipline, and efficiency, and this culture will continue to exist. Therefore, I believe that for these three reasons, we believe that our profit growth will continue to outpace revenue growth in the second half of this year and beyond.

Q9: Synergy in the gaming business?

In general, there are three major types of games in China. Competitive esports games, which are evergreen games. TME-SW has a very strong position in this market, generating cash flow for us for decades, rather than just a few years. Secondly, there are games driven by more stories or content, which has been our weaker area. In the past few months, competitors have launched many very good products. However, we also have some large narrative-driven, content-rich games in development, and time will tell how successful they are. The third type is casual games. In the West, there is a new casual game based on applications that becomes popular every year or two.

But in the past five years, we have been closely following game platforms, especially mini-game platforms. We believe that in terms of users and revenue, our platform is more than five times larger than any app-based casual game. As new casual game experiences appear on the platform, it is growing at an extremely fast pace year by year. In our view, mini-game platforms are largely incremental rather than cannibalizing our core games.

Q10: Macro environmental challenges, what impact do they have on the gaming business?

The macro environment is facing challenges as consumers are turning to lower-priced entertainment experiences, shifting from goods to services. In theory, this is a good thing for the gaming industry. By comparison, ticket sales in China's cinema industry have been very strong in the past 2 to 3 months as people seek affordable entertainment experiences rather than high-priced luxury goods.

Regarding consumption, what we see is that consumption is recovering from the COVID-19 era, but it may not be as fast as the market expects or hopes. However, we also see that the government's focus on supporting consumption growth is actually very clear. At the same time, the government is implementing a series of policy measures to promote economic growth. Meanwhile, we also believe that there is a lot of resilience and entrepreneurial spirit in the Chinese economy.