After delivering a "royal flush" performance in Q1, the stock price of $TENCENT.HK did not show a particularly grand momentum. In the past few days, due to the mediocre performance and weak guidance of its subsidiaries, Yuewen and Tencent Music, some funds were disappointed and fled. Tencent itself was also affected: despite knowing that Q2 performance would be boosted by DNFM, and definitely not bad, the market remains cautious in such a relatively low valuation.

So how did the stock king actually perform? Although the current environment is complex, the "disconnect" between Tencent Music's current performance and the actual stock price reaction from yesterday indicates that the management's guidance and outlook for the second half of the year have a greater impact on short-term valuation. However, the current performance still reflects some changes in the company's operations and strategies, which is relatively important for judging the company's value from a medium to long-term perspective.

Let's start with the key points:

1. Advertising: Breaking the counter-cyclical trend

Market expectations for Tencent's advertising actually went through a change from conservative to positive, and then back to conservative. Initially, due to a high base, the market was relatively cautious in its expectations at the beginning of the quarter. However, with the continued efforts in Video Number, Mini Program Games advertising, industry expert research, as well as the company's guidance and outlook for Q2 performance, the market gradually became optimistic.

But with the marginal softening of China's economic data in June, market expectations quickly adjusted, and some funds began to worry about Tencent's advertising performance. In fact, there was still a 20% growth in the second quarter, mainly driven by Video Number advertising and Mini Program Games advertising, with a small contribution from Tencent Video and Tencent Music. This is precisely an Alpha growth logic that few peers possess.

However, given the sustained pressure in the macro environment, it is uncertain whether the strong growth can be maintained in the second half of the year. It is recommended to listen to the management's outlook during the conference call. However, compared to peers, whether in terms of advertising formats, growth in advertising inventory, or the upgrade of its own 3.0 advertising system to improve ROI, Tencent's relative advantage is still evident.

2. Gaming: Growth picking up, deferred holding steady

Signs of gaming recovery were already evident in the previous quarter, coupled with the dominance of DNFM for months, so market expectations were not low. The domestic performance was better than originally anticipated, with a 9% year-on-year growth, while the market mostly expected 5-8%. Although the overseas market had the outstanding performance of "Squad Busters" contributing incremental growth, it did not meet the market's expected increase.

In terms of deferred revenue, Q2 accelerated repair year-on-year, but remained flat quarter-on-quarter. Dolphin Jun believes that although DNFM went online at a royal flush level in Q2, hindered by the fact that Q2 itself is a low season (it is customary for deferred revenue to decline quarter-on-quarter), industry pressures (year-on-year decline), and DNFM only contributing a month of revenue, this deferred performance is also acceptable.

Looking at the current bestseller rankings in July and August, with DNFM continuing to top the charts and Peace Elite showing a continuous recovery, there is no need to be overly concerned about the deferred performance.

Of course, in the medium to long term, there is a need for continuous high-quality new products, as well as operational innovation for old games. These are the capabilities where Tencent has underperformed in the past few years, especially the former. Therefore, it is recommended to continue to pay attention to the company's further adjustments to the gaming business and pipeline updates.

3. Kingsoft Enterprise Services: Payments Best Reflect Macro Pressure

The main part of Kingsoft Enterprise Services is the payment business (estimated to account for nearly 70% of revenue by Dolphin Jun), but due to weak consumption, both payment and credit revenue are under pressure. From the industry performance perspective, the reserve funds turned over by third-party payment institutions have seen a year-on-year decline for the first time in recent years, and Tencent has also reported a decrease in credit revenue, reflecting macro pressures.

Additionally, the 30% share of enterprise services is still in a growth stage, with incremental revenue from video number e-commerce commissions and commercialization of WeChat Enterprise bringing growth to cloud services.

4. Gross Margin Improvement Logic Remains Unchanged, but Expenses Rise

The logic of gross margin improvement due to the reuse of internal resources and changes in business structure (video number advertising, mini-game) has been discussed for over a year, and the improvement trend continued in Q2.

However, in terms of operating expenses, sales expenses have increased normally due to the launch of major new games, and research and development expenses may have increased due to the development of games, AI-related products, or technologies. Specifically, there was a 6% increase in research and development personnel compensation (with a net increase of 719 employees in the group), and a 17% increase in bandwidth server costs.

Ultimately, the main operating profit that Dolphin Jun has always paid attention to (excluding other non-operating related income) increased by 33% year-on-year, with a 2% decrease in profit margin compared to the previous quarter, which is in line with expectations. Due to changes in effective tax rates (comprehensive tax rate decreased by 12% year-on-year, due to deferred income tax adjustments of overseas subsidiaries), the final Non-IFRS attributable net profit increased by 53% year-on-year, seemingly exceeding expectations.

Although the trend of efficiency improvement in the second quarter was once again disrupted, Dolphin Jun still believes that Tencent has operational efficiency improvement potential in the medium to long term. On the one hand, the current absolute scale of the workforce is huge, and relative to the current mature business models, it still appears bloated; secondly, new technologies such as AI require short-term investment, but in the medium to long term, they will help optimize internal efficiency of the enterprise. The addition of employees in Q2 does not mean that Tencent has entered a new investment cycle. Considering social impact and short-term operational changes, a rolling incremental optimization strategy remains the direction of the stock king.

5. Sell-off Repurchase: Doubling Repurchases to Absorb Major Shareholder Sell-offs

In the second quarter, the group's overall net cash (cash + deposits - long and short-term interest-bearing debt) was 71.8 billion, a decrease of 20.7 billion compared to the previous quarter, mainly due to a significant increase in repurchases (a 250% increase to 52.3 billion Hong Kong dollars quarter-on-quarter, maintaining 1 billion Hong Kong dollars per day on trading days) leading to outflows.

Currently, the repurchased shares have been cancelled, and by the end of the second quarter, the total shares of the group decreased by 0.4% quarter-on-quarter. This year's trillion-dollar repurchase plan is one of the core logics that the market is bullish on Tencent. Assuming that the remaining trading days in the year continue at a daily repurchase pace of 1 billion (which has been maintained up to now), the total repurchase amount is expected to exceed 160 billion Hong Kong dollars. In addition to an expected 33 billion RMB in dividends, the overall shareholder return rate remains high at 5.6%, which is an important reason for attracting funds to bet on in a rate-cutting cycle environment.

The major shareholder has sold 39.7 million shares in the past 3 months since May 14, slightly accelerating compared to the average monthly selling pace in the previous period (12.5 million shares/month). However, due to Tencent's larger repurchase and cancellation efforts (40 million/month), as of the end of the second quarter, the major shareholder's shareholding ratio has not changed much, still at 24.34%.

6. Detailed Financial Report Data Overview

Dolphin's Viewpoint

The performance of the stock king is still strong, but market expectations are relatively accurate. Ultimately, mainly due to fluctuations in taxes and fees, the Non-IFRS profit exceeded expectations. From Dolphin's perspective, such outperformance is not highly valued. With the current implied valuation of 16x EV/Non-IFRS net profit, although it is relatively low, the short-term focus will mainly be on market funds' marginal changes, and the reaction may be relatively flat.

Of course, the Q2 performance is not without highlights. The resilience of advertising is better than we expected. The strong performance of the advertising business will also continue to drive the upward trend of gross profit margin.

However, as seen from Tencent Music's performance yesterday, the market's reaction to performance is more focused on the expectations for the second half of the year (TME's weak guidance on paid users for the second half of the year led to a sharp drop in stock price). If the outperformance is pinned on advertising performance closely tied to the macro environment, it can be said that risks and rewards coexist. The good news is that there is still incremental growth in video accounts, mini-programs, and the 3.0 advertising system's attraction to more advertisers. The bad news is that the macro environment currently lacks a visible turning point for recovery. Although Tencent is definitely more countercyclical than its peers, market expectations are still high, with growth of over 15%.

This also means that if consumer demand continues to weaken and margins decline, even a strong company like Tencent may not be able to meet the market's high expectations.

But the stock king is still the stock king. When facing a valuation adjustment due to macro factors, the over 100 billion repurchase will once again play an effective support role. As Dolphin mentioned earlier, if Tencent continues to maintain the current pace of repurchases, the current dividend yield of 5.6% is a very strong support point in a rate-cutting cycle. Conversely, if there are further adjustments, the stock king can attract incremental funds more than most other Chinese assets.

Looking ahead, Tencent's performance in the third quarter is not necessarily going to be poor. Moreover, whether from the perspective of cost reduction and efficiency improvement, as mentioned earlier, Tencent still has a lot of room for adjustment. The specific pace of progress is in the company's hands. It is not ruled out that when facing pressure on revenue, they may release more profits.

Therefore, even with macro influences, we expect Tencent not to face a situation of both performance and valuation being hit hard. This is already much better than the performance of most Chinese assets in this round of financial reporting season as expected by Dolphin. Furthermore, if the rate-cutting cycle officially begins, with increased room for domestic policy adjustments and expectations turning around, both valuation and performance are likely to rebound. **

Detailed Analysis Below

I. User Ecosystem: WeChat Stable Growth, QQ Hope Diminishing

In the second quarter, WeChat had 1.371 billion users, with a net increase of 12 million compared to the previous quarter, showing a stable expansion trend that exceeded expectations. QQ also saw a resurgence, with a net increase of 18 million users.

Stable traffic can continue to support the deepening commercialization of the WeChat ecosystem, while the changes in QQ still need further observation to determine if it is just a short-term fluctuation.

The number of paid value-added service users continued to rebound in Q2, with a net increase of 3 million compared to the previous quarter. Despite being the off-season, the growth in subscription members for Tencent Music and Tencent Video, as well as the increase in game users brought by the launch of DNFM, will all contribute to the incremental growth.

However, although several dramas on Tencent Video became popular in the second quarter, such as "Yu Feng Xing", "Joy of Life 2", and "The Story of the Rose", the increase in membership was only 1 million compared to the previous quarter. According to Questmobile data, more users still choose to spend their time on platforms like Douyin and Xiaohongshu. Even long video platforms like iQiyi and Mango TV performed poorly in comparison.

Currently, the total number of long video members in the industry is only around 200-300 million, which at most corresponds to 1 billion internet users, assuming an average of three users per household, totaling over 300 million potential accounts. Currently, Tencent Video has 116 million users, iQiyi has around 100 million, and Youku + Mango are also expected to have around 100 million members, dividing the industry equally among them.

Reaching the industry peak is also the main reason for Tencent Video's continuous optimization of project investment and the shift towards focusing on ROI. Over the past year, Tencent's media content costs have continued to decrease, with a 15% year-on-year decrease in the second quarter, reflecting the current strategy of investing in "less but better" content.

II. Gaming: Rapid Recovery as Scheduled

In the second quarter, the revenue of online games reached 485 billion, a year-on-year increase of 9%, meeting the positive market expectations

Domestic Market grew by 8.8%, slightly higher than market expectations. The growth drivers were mainly new games, one being "Fearless Agreement" and the other being "Dungeon & Warrior Mobile Game" (launched at the end of May, contributing revenue for only 40 days in the second quarter).

In terms of performance of existing games, due to the off-season, the growth may not be significant. However, under continuous operational optimization, "Peace Elite" has shown improvement in user engagement, so revenue performance is expected to have a significant recovery.

Overseas Games grew by 9.4%, still driven by "PUBG Mobile," Supercell's "Brawl Stars," and the new game "Squard Busters." However, the revenue growth confirmed was lower than market expectations. Further explanation may be needed during the conference call to see if there are factors affecting revenue recognition period.

Combining revenue indicators calculated from deferred revenue can better represent forward-looking indicators of real demand. Deferred revenue in the second quarter increased by 14.6% year-on-year and remained flat quarter-on-quarter. Dolphin believes that although there was a blockbuster game "DNFM" launched in Q2, factors such as Q2 being the off-season by nature (a decrease in deferred revenue quarter-on-quarter is customary), industry pressure (year-on-year decline), and DNFM contributing revenue for only one month, make the performance of deferred revenue acceptable.

Looking at the current bestseller rankings for July and August, DNFM continues to rank first, and "Peace Elite" is showing a continuous recovery, so there is no need to be overly concerned about the deferred revenue performance. Currently, DNFM's revenue has surpassed "Honor of Kings," and it is expected that the first December revenue is likely to reach 20 billion.

Of course, in the medium to long term, there is still a need for continuous high-quality new products and operational innovation for existing games. These have been areas where Tencent's performance has been lacking in recent years, especially the former. Therefore, it is recommended to continue monitoring the company's further adjustments to the gaming business and pipeline updates: the third quarter's new product reserves are weaker compared to the second quarter, with focus on "Delta Operation," "Locke Kingdom Mobile Game," "Dawn of Stars," and the performance of "Need for Speed," which was launched in July, was lower than expected Need to see how to reinvigorate through operations.

Although DNFM Games only contributed for a little over a month in the second quarter, Tencent Games' performance is leading the industry. In the second quarter, the domestic game market size once again decreased year-on-year, with new games concentrated in the third quarter. The relative vacancy in the second quarter is partly due to this. However, with stable issuance of game licenses, various manufacturers choosing to concentrate on the summer season in the third quarter may also indicate that the impact of consumer downgrading has reached the gaming industry. Game manufacturers rarely launch heavyweight products, relying on the peak season to achieve ideal performance in public testing.

III. Advertising resilience is strong, but macro pressures in the second half of the year cannot be ignored

In the second quarter, Tencent's advertising revenue maintained a year-on-year growth rate of 20%, naturally slowing down from the 26% growth rate in the first quarter due to a high base. Although it slowed down, this performance is already good in the persistently weak macro consumption environment.

The growth of advertising in the second quarter mainly relied on video accounts and mini-program game ads, with user time spent on these two features increasing by 20% each. Among them, the revenue from mini-program games also increased by 30%, indirectly reflecting the good growth of mini-program game ads.

Roughly estimated by Dolphin, excluding the incremental impact of video accounts (external circulation + e-commerce ads totaling 6-7 billion, a year-on-year growth of 105%), the remaining advertising growth rate is expected to also have a high single-digit growth. We believe that the incremental growth of traditional ads should mainly come from the revenue sharing of mini-game incentive ads.

In addition, media ads may have also slowed down the declining trend. In the second quarter, Tencent Music's advertising growth continued to be strong, and Tencent Video continued to air hit dramas, so ad repairs are expected to make certain contributions.

Looking ahead to the second half of the year, given the continued pressure of the macro environment, it is hard to say whether Tencent can maintain absolute strong growth in the second half of the year. It is recommended to listen to the management's outlook during the conference call. However, compared to peers, whether in terms of ad formats, ad inventory growth, or the upgrade of their own 3.0 ad system to improve ROI, Tencent's advantages are still evident.

IV. Tencent Financial Technology: Payment further slows down, incremental growth comes from video accounts and WeChat Work

In the second quarter, Tencent Financial Technology grew by 3.7% year-on-year, lower than market expectations, making it the sector that best reflects the macro beta among the three major businesses. This is mainly because 70% of the revenue comes from payment services, and Tencent has not made any new moves in payments recently that could bring incremental growth.

Under macro pressure, offline payments have further slowed down. This is not only reflected in WeChat Pay, but also in the overall performance of the social retail sector in the second quarter. Coupled with the high base brought by the demand release just after the end of the epidemic last year, the third-party payment institutions' reserve funds disclosed by the central bank directly decreased year-on-year.

Therefore, the incremental growth in the second quarter is still in video account commissions and cloud services (Enterprise WeChat commercialization). After deducting the 1.5 billion yuan of video account commission income (Dolphin's forecast value), it implies that cloud services still have high single-digit growth.

V. Investment gains: Significant increase in profits from joint ventures

Regarding investment gains, based on the original indicator definition, Dolphin mainly looks at other income net amount (including investment income according to the original definition), and profits from joint ventures/associates:

1) Other income net amount of 865 million, asset disposal is still not low, but the market volatility has led to a significant amount of impairment in investment companies.

After a significant increase in asset disposal income at the beginning of the year, although there was a slowdown in the second quarter, there was still a significant growth. Combining with the company's statement in the previous quarter that the capital needed for the investment portfolio is basically internally resolved and will not use funds outside of the investment business. The pressure to repurchase + investment in new technologies such as AI may continue to drive Tencent to maintain higher investment asset disposal than last year.

If we look at the income brought by the appreciation of investment assets alone, it remains slightly positive, mainly from the accelerated disposal actions. Although the fair value has increased, the domestic capital market quickly fell back at the end of Q2, so the increase in fair value was relatively small.

2) In the second quarter, profits from joint ventures/associates amounted to 7.7 billion, indicating that the profitability of invested companies is further improving, such as Pinduoduo, Kuaishou, etc., and we can expect the performance of related companies accordingly.

As of the end of the second quarter, the total scale of joint/associate assets of the company was 270.2 billion, combined with the current profit share of 7.7 billion, the calculated investment return rate for Q1 was 2.9%, significantly higher than the previous few quarters

VI. Gross margin improvement logic remains unchanged, but expenses rise

Revenue improved in the second quarter. Although the Non-IFRS attributable net profit, which the market has always focused on, increased by 53% year-on-year, exceeding market expectations, the difference in expectations mainly came from changes in the effective tax rate. The operating profit reflecting the main business grew at a slower pace of 33%, just meeting expectations.

However, beyond expectations, this profit growth rate is still impressive. It is mainly due to the unexpected improvement in gross margin brought about by changes in business structure (increased gross margin from video ad, video commission, and small game ad). Cost optimization from several perspectives in the past did not appear in Q2. Instead, with the increase in personnel and the new game product cycle, both R&D expenses and sales expenses increased year-on-year. In addition, the optimization cycle of server depreciation mentioned in the previous quarter was further confirmed in this quarter, with Q2 bandwidth server expenses increasing by 16% year-on-year.

Although the efficiency improvement trend in the second quarter was once again broken, Dolphin believes that Tencent still has operational efficiency potential in the medium to long term. On the one hand, the absolute size of the current employee base is huge, and relative to the current mature business model, it still appears bloated; secondly, new technologies such as AI require short-term investment, but in the medium to long term, they will help optimize internal efficiency of the enterprise. The addition of employees in Q2 does not mean that Tencent has entered a new investment cycle. Considering social impact and short-term operational changes, a rolling incremental optimization approach remains the strategic direction for the stock king.

On a more macro level, looking at the current strategic direction of the group, it is difficult to see the kind of large-scale investment as in previous years. On one hand, there are regulatory restrictions (such as anti-monopoly measures), and on the other hand, it stems from the group's stricter control over profit fluctuations. Based on a steady operation and a responsible attitude towards shareholders, the group will still focus on improving operational efficiency while expanding its business.

VII. Selling Pressure and Repurchase: Doubling Repurchases to Absorb Major Shareholder Selling

In terms of repurchase volume, Tencent continues to increase its repurchases, with a 250% increase compared to the previous quarter: it repurchased 155 million shares in the second quarter, spending 52.3 billion Hong Kong dollars. The repurchased shares have been cancelled, resulting in a 0.4% decrease in total shares compared to 1Q24.

Compared to our statistics in May, major shareholder Prosus has sold 39.7 million shares from May 14 to the present within the past three months, slightly accelerating compared to the average monthly selling pace in the previous period (12.5 million shares/month). However, due to Tencent's greater cancellation intensity in repurchases (40 million/month), as of the end of the second quarter, there has been little change in the major shareholder's ownership percentage, which remains at 24.34%. Its net assets per share/stock price ratio is 62.53%, resulting in a discount rate of 37.46%, which has seen some improvement since the second quarter.

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2022 August 17 Financial Report Review "360 Degrees Uncovering Tencent: Is It Really That Bad?"

2022 May 18 Conference Call "Growth Guidance for This Year Depends on the Epidemic (Tencent Conference Call)"

2022 May 18 Financial Report Review "Tencent: Stock King Still Crossing Tribulations"

2022 March 23 Conference Call "In an Industry Slowdown, High-Quality, Healthy Growth Comes First (Tencent Conference Call Summary)"

2022 March 23 Financial Report Review "Tencent: Stock King Still 'Squatting'? The Moment of Testing Faith Has Arrived"

In-depth

2023 January 6 "Entertainment Sector's Strong Start, Tencent, Bilibili, Whose Rebound is More Sustainable?"

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