Macro pressures exist, but Tencent is not lacking in profit adjustment points (2Q24 conference call minutes)

The following is the summary of the second quarter financial report conference call for $TENCENT(00700.HK) in 2024. For financial report analysis, please refer to "Tencent: A 360-Degree Breakdown of the "Awesome" Performance" here.

I. Review of Core Financial Information:

II. Detailed Content of the Financial Report Conference Call

2.1. Key Points from Management's Statements:

1) Business Progress

① Overall Performance

a. In the second quarter of 2024, Tencent's total revenue reached RMB 161 billion, an 8% year-on-year increase.

b. Gross profit was RMB 85.9 billion, a 21% year-on-year increase, demonstrating the strength of the platform plus content strategy.

c. Value-added services accounted for 49% of total revenue, with social networks accounting for 19% and games for 30%.

② Domestic Games

a. Domestic game revenue accounted for 21% of total revenue, a 9% year-on-year increase to RMB 35 billion, mainly driven by "Fearless Alliance" and "Dungeon & Warrior Mobile".

b. The domestic game business saw significant growth in total revenue and income, further consolidating its market position.

③ International Games

a. International game revenue accounted for 9% of total revenue, a 9% year-on-year increase to RMB 14 billion, mainly driven by "PUBG Mobile" and Supercell games.

b. The total revenue of the international game business saw a significant year-on-year growth, with growth exceeding income, demonstrating strong market performance.

④ Social Networks

a. The combined monthly active users of WeChat and WeChat grew year-on-year and quarter-on-quarter to 1.37 billion, further expanding the user base.

b. The usage time of video account users saw a significant year-on-year growth, with the number of creators with closed-loop income tripling year-on-year, reflecting the vitality of the content ecosystem.

c. The revenue contribution of the social network business in value-added services was 19%, mainly benefiting from the increase in music and video subscription revenue.

⑤ Online Advertising Business

a. The online advertising business accounted for 19% of total revenue, with revenue growing by 36% year-on-year to RMB 17 billion.

b. Video account advertising revenue grew by over 80% year-on-year, and the gross profit margin of long video advertising also improved, driving overall advertising business growth.

⑥ Financial Technology and Business Services a. Financial technology and business services accounted for 31% of total revenue, with gross profit increasing by 29% year-on-year to RMB 24 billion.

b. Despite a slowdown in consumer spending, the number of commercial payment transactions continued to grow year-on-year, maintaining overall market share stability.

c. Revenue from cloud services increased, driven by higher technical service fees from Video Number and value-added services, leading to revenue growth in business services.

⑦ Content Strategy, AI, and Technology Investment

a. Tencent Video achieved significant audience and subscriber growth through TV dramas adapted from works by China Literature Limited and produced internally.

b. Tencent launched three AI-driven platform solutions, including image generation engine, video generation engine, and knowledge engine, applied in areas such as advertising content creation and customer service.

c. Corporate clients are increasingly adopting Tencent's supercomputing infrastructure and model library services, driving external revenue growth related to artificial intelligence.

2) Financial Performance

① Revenue and Profit

a. In the second quarter of 2024, total revenue was RMB 161.1 billion, an 8% year-on-year increase.

b. Gross profit was RMB 85.9 billion, a 21% year-on-year increase, operating profit was RMB 50.7 billion, a 40% year-on-year increase, mainly benefiting from the growth of high-margin revenue streams and cost control.

c. Calculated according to non-International Financial Reporting Standards (Non-IFRS), operating profit was RMB 58.4 billion, a 21% year-on-year increase.

d. Net profit attributable to shareholders was RMB 37.3 billion, a 53% year-on-year increase.

② Gross Margin

a. Overall gross margin was 53%, a 6 percentage point year-on-year increase.

b. Value-added service gross margin was 57%, a 3 percentage point year-on-year increase.

c. Online advertising gross margin rose to 56%, a 7 percentage point year-on-year increase, mainly due to the growth of high-margin Video Number advertising revenue.

d. Financial technology and business services gross margin rose to 48%, a 9 percentage point year-on-year increase, benefiting from improved cost efficiency in cloud business and increased contribution from high-margin revenue.

③ Expenses

a. Sales and marketing expenses were RMB 9.2 billion, a 10% year-on-year increase, mainly due to increased game advertising spending for new content releases.

b. Research and development expenses were RMB 7.3 billion, an 8% year-on-year increase.

c. Administrative expenses were RMB 10.2 billion, a 9% year-on-year increase, mainly due to increased employee costs.

④ Cash Flow and Capital Expenditure

a. Operating capital expenditure was RMB 7.2 billion, a 144% year-on-year increase, free cash flow was RMB 40.4 billion, a 35% year-on-year increase, benefiting from increased game revenue.

b. Net cash position for the quarter was RMB 71.8 billion, a 42% decrease from the previous quarter, mainly due to share repurchases and RMB 28.9 billion in dividend payments.

⑤ Shareholder Returns and Earnings Per Share

a. Diluted earnings per share were RMB 6.014, a 35% year-on-year increase, mainly due to a reduction in the number of shares as a result of share repurchases 2.2 Q&A Analyst Q&A

Q: Can management provide a detailed explanation of the recent upgrade to the advertising technology platform? How will these upgrades attract more advertising spending and support the potential growth of future advertising revenue?

A: Our recent upgrade to the advertising technology platform includes reviewing user behavior data over a longer time span, covering historical data over many years rather than just a few months. The main benefit of this approach is to form a more comprehensive user interest graph. Additionally, we are more frequently monitoring users' recent behavior to more accurately capture their current commercial intent. This upgrade enables us to target ads more precisely, thereby increasing click-through rates. The improvement in click-through rates naturally attracts advertisers to increase spending, as higher click-through rates mean advertisers can reach their target audience more effectively and at a lower cost.

Q: Will the supportive comments from the State Council on digital content, including games, change the company's future deployment of R&D resources to promote more opportunities for entertainment-related content consumption?

A: The supportive comments from the State Council regarding our content business, especially the gaming business, are a very positive signal. This not only recognizes the value of the industry but also encourages us to continue investing in content creation. We have made long-term strategic investments in the content industry, including games and TV series adapted from novels. The results of these investments are gradually becoming apparent, with clear returns seen in the recovery of the gaming business and the success of TV series. Therefore, we will not adjust our strategy based on a single piece of news, but will continue to adhere to long-term, strategic content investments to ensure our competitive advantage in the industry.

Q: Could management share the e-commerce strategy of Video Accounts, especially in the context of slowing growth in GMV of competitors' short video platforms and e-commerce?

A: In the e-commerce activities within the WeChat ecosystem, our Video Accounts and live e-commerce have shown very robust growth in this quarter, with a considerable increase in GMV. Our Video Accounts e-commerce scale is relatively small, so there is still a lot of room for growth compared to other short video platforms.

We have recently repositioned live e-commerce to be part of the WeChat e-commerce system, building an e-commerce ecosystem that integrates all elements of the WeChat ecosystem, including official accounts, mini-programs, enterprise WeChat, as well as social and community activities within WeChat. Through this systematic approach, we aim to provide a more valuable e-commerce experience for merchants and users, break through the growth ceiling of traditional live e-commerce, and create higher growth potential.

Q: Management expenses increased by 8% year-on-year, with almost flat employee numbers. How much of this 8% growth is one-time? Also, how to predict the effective tax rate for the next few quarters?

A: The growth in management expenses is divided into two parts: R&D expenses and management expenses excluding R&D expenses, both of which increased by 8% to 9% year-on-year in the second quarter of 2024. It is expected that the full-year growth of R&D expenses and management expenses in 2024 will be in the high single digits. Regarding income tax, the full-year IFRS effective tax rate for 2023 was 22%, while the non-IFRS effective tax rate for 2024 is expected to be between 18% and 20% The decrease in income tax expenses is mainly due to the reversal of deferred income tax from overseas subsidiaries in the second quarter of last year, while the increase in domestic income tax partially offset this impact.

Q: This year, we have seen a resurgence in the growth of domestic and international games, with adjustments to existing games, the release of new games, and the strong performance of Supercell all performing exceptionally well. What are your future plans? How will you smooth out this growth trend so that investors can see sustainable multi-year game revenue growth?

A: We do not specifically pursue the smooth growth of total game revenue. Due to accounting reasons, we defer the revenue of total game revenue to future years in some cases, which makes the financial performance itself smoother.

However, from a business perspective, in addition to "Dungeon & Fighter Mobile" being a significant contributor, we have other contributors as well, such as the release of "Fearless Pact" in China, which has made a significant contribution to our revenue growth. We are also continuing to drive the growth of some evergreen games, such as "League of Legends Mobile" and "Battle of Golden Shovel". Additionally, we have some games in development, such as "Delta Force", "Path of Exile 2", and "One Piece", which have the potential to become future evergreen games.

We are aware that the gaming industry has a certain degree of cyclicality, where growth may slow down when there is insufficient innovation, but rapid growth tends to occur when new innovations emerge. We will continue to strive for innovation to develop the business over a longer period, but also need to recognize the volatility within the industry.

Q: What are your current divestment plans? Are there some significant assets available for distribution, or have some assets become liquid now? How do you view the divestment approach and the new investment areas you are considering?

A: The amount of asset disposals in the second quarter of this year far exceeded the amount of new investments. If we add up divestments, dividends received, and fund distributions, this amount is 50% higher than the funds we invested in new investments. Most of our investment portfolio value is in listed companies, and most are relatively large and highly liquid listed securities.

Therefore, in the second quarter, we sold over $1 billion worth of shares in the market, and this trend is expected to continue. We will continue to evaluate and optimize our investment portfolio to achieve self-sustaining goals while seeking new investment opportunities.

Q: The advertising business achieved a 19% growth in the second quarter, performing more steadily than expected. What are the different initiatives in Video Number and other forms of advertising? How have advertisers' behaviors changed in the current dynamics? How is the company responding to macro fluctuations?

A: We have not made significant changes but continued to execute along the established path. Our growth is mainly attributed to deploying neural network AI on GPU infrastructure to improve ad click-through rates and the gradual transition of advertising formats within WeChat to closed-loop advertising, both of which help improve cost per mille (CPM) and click-through rates. Additionally, although we did not release more ad inventory in the first half of this year, especially in Video Number, we still achieved good growth.

Q: What are the new developments in the company's AI integration progress? Especially in the training and application exploration opportunities of large-scale language models, as well as how to strategically improve efficiency and adoption rates?

A: We view AI as a comprehensive component, not just large language models. We have made significant progress in improving content recommendations, video recommendations, and ad recommendations through AI. For example, in the video section, AI-driven content recommendations have greatly increased user engagement. In ad recommendations, even a 10% increase in conversion rates can significantly boost revenue.

In the gaming field, we use AI to bridge the gap between PVE and PVP, making machine battles more realistic and enjoyable. As for large language models (LLM), we have developed a leading MOE architecture model in China and introduced interactive features with LLM in the Yuanbao app (AI assistant). Users can now get direct answers through enhanced search functions, with positive feedback so far. We will continue to improve and gradually integrate LLM into different parts of the company's ecosystem.

Q: Could the management discuss Tencent's position in the AAA game investment cycle? Can you provide an update on the latest progress?

A: We believe that AAA game development is not just a fixed cycle but an evolving trend. As the gaming industry continues to grow, the development budgets for top games are increasing, requiring us to maintain high competitiveness in this area. We continue to invest in the development of high-quality games and reflect these costs directly on the income statement rather than capitalizing them, emphasizing our focus on financial transparency.

The boundary between AAA games and other types of games is becoming increasingly blurred. For example, the upcoming game "Delta Force" combines a movie-level AAA experience with competitive PVP modes, showcasing not only our ability in developing content-driven games but also providing significant potential for blurring the boundaries between PVP and PVE through AI technology in the future. This innovation will greatly enhance players' gaming experience and help us maintain a leading position in the competitive market.

Q: The cross-fusion of literature or existing PC game development plays an important role in driving the growth of long videos and mobile games. Can you discuss the revenue potential of "King of Glory World" and other IP reserves with revenue potential?

A: Regarding "King of Glory World," we have been actively advancing its development process, and the game is highly anticipated within the industry and player community. In addition to "King of Glory World," we are also vigorously exploring and utilizing existing strong IP resources to drive the dual development of games and content. For example, "Fearless Covenant" has become one of the most popular PC games in the Chinese market, and we plan to replicate this success on mobile platforms, recently obtaining distribution licenses in China.

Furthermore, we are exploring multiple potential IPs created by Chinese literature and Tencent Animation, which can not only support the expansion of existing content but also serve as the foundation for future game development, further driving our revenue growth in the gaming and long video sectors. This cross-domain integration and development of IPs provide us with broad market space and long-term growth potential

Q: Regarding "Dungeon & Fighter Mobile," since its launch at the end of May, the game has shown strong initial momentum. How do you view the sustainability of this game? Considering the unique nature of the game, what are its sustainability and prospects?

A: We are confident in the long-term sustainability of "Dungeon & Fighter Mobile."

Firstly, the PC version of "Dungeon & Fighter" has been successfully operating for 16 years, demonstrating our deep experience in operating and maintaining this type of game.

Secondly, since the launch of "Dungeon & Fighter Mobile," the game has shown a very high user retention rate, especially in the first 30 days of the game's lifecycle, which is typically a key indicator of a game's future vitality.

Furthermore, due to the unusually long development cycle of "Dungeon & Fighter Mobile," we have prepared a year's worth of rich content that will be released in stages, ensuring players always have a fresh experience. Therefore, we believe that this game can not only remain active in the short term but also continue to attract players in the long term, becoming another long-lasting game for us after "King of Glory" and "Peace Elite."

Q: In terms of financial technology business, due to weak consumer environment and high sensitivity to prices, the growth rate of the business has been affected. Have you observed any changes in consumer financial product transactions on the WeChat platform? Are these changes structural or cyclical?

A: In terms of payment business, we have observed a continuous increase in the number of commercial payment transactions, reflecting the resilience of commercial activities. However, the average transaction amount has decreased, indicating that consumers are more cautious about spending in the current economic environment, especially in high-value transactions.

In the credit business, consumer behavior has also changed, with many people preferring to increase savings rather than engage in large credit consumption. Due to risk management considerations, we have also proactively tightened our credit issuance policies to address the current macroeconomic and weak consumption conditions.

At the same time, our wealth management business has shown a growth trend, as in an uncertain economic environment, consumers are more willing to invest funds in savings and investment products rather than direct consumption. We believe these trends reflect deeper structural changes rather than just short-term economic fluctuations. With the government introducing proactive economic stimulus policies, we expect consumer confidence and overall economic vitality to gradually recover in the future, which will bring new growth momentum to our financial technology business.

Q: There have been recent news reports about the tense relationship between Chinese app store owners and game developers, involving issues such as fees and external payment systems. How do you view the challenges and opportunities of this issue for your investment portfolio? Can reducing payment costs increase the gross profit margin of the gaming business? Or should we adopt a more cautious attitude towards certain elements of the WeChat ecosystem?

A: Indeed, the tension between the gaming industry and app stores is a long-standing issue, mainly due to the 30% fee that app stores charge for digital content, which is considered a heavy burden. App stores believe they provide a favorable ecosystem that supports the monetization of this digital content, but the gaming industry believes that this burden should not be borne solely by digital content providers, but should be more fairly distributed among all goods and service providers With the passage of time, we expect to see a gradual decrease in the proportion of fees charged by app stores, whether due to regulatory reasons or commercial pressures. For us, as you mentioned, the game "Dungeon & Fighter Mobile" has a strong IP influence, so we have decided to primarily release it through internal channels rather than app stores. This decision has allowed us to achieve higher returns while ensuring the quality of user experience.

As for other games to be released in the future, each game has different characteristics, and we will still cooperate with app stores based on specific circumstances. In this process, we will carefully weigh the interests to ensure that we can achieve the best balance in all aspects. Regarding the discussion on iOS mini-programs, I believe there are some misunderstandings here. Currently, we are not monetizing mini-programs through in-app transactions on iOS. However, if we can reach a consensus under economically sustainable conditions in the future, it will result in a win-win situation for us, Apple, game developers, and users. If discussions do not progress, the status quo will be maintained, but we still hope to achieve a result that benefits all parties.

Q: Can you provide a detailed explanation of our views on the contribution of AI-related revenue from high-performance computing infrastructure and model library services, as well as AI solutions provided to enterprises, to our future cloud revenue?

A: In China, renting GPUs to other companies with AI needs has become a rapidly growing business. Although this trend is smaller in scale in China compared to the US due to the lower capitalization of Chinese startups compared to the giant VC funding of startups in the US, we see rapid growth in customer demand for renting GPUs to meet their AI needs in our cloud business. Although the base is small, the growth rate is very high. However, it is worth noting that part of this demand growth has partially replaced the demand for renting CPUs. Therefore, while the GPU rental business is performing well, the overall CPU processing business remains relatively stable.

Q: Considering the current macro uncertainty, do we have plans to expand our share repurchase program?

A: Currently, we are continuing to execute the previously announced share repurchase program, and there are no new updates at the moment.

Q: How do we view the long-term sustainability and scale of the game "Dungeon & Fighter Mobile"? Compared to "King of Glory" and "Peace Elite," how does its daily active user base or revenue potential fare?

A: As a narrative-driven game, we expect the daily active user count of "Dungeon & Fighter Mobile" to be lower than system-driven games like "King of Glory" and "Peace Elite." However, the average revenue per user (ARPU) of this game may be higher because its user base is more mature and has stronger payment capabilities. Especially considering that this game is built on a 16-year legacy, many players who used to play "Dungeon & Fighter" PC version during their college days are now in society with stronger payment capabilities. Nevertheless, compared to other narrative games, "Dungeon & Fighter Mobile" has a larger user base and higher daily active users, and we believe its monetization capability is sustainable

Q: What are the trends in the macroeconomy? How is the performance of the payment business? Can the game and advertising businesses maintain resilience in this macro environment?

A: Currently, we see that consumer growth is consistent with official data, with consumer growth in the second quarter slowing compared to the first quarter. Nevertheless, we believe that with the government introducing more proactive policies and expansionary measures, the economy and consumer spending will gradually recover.

Regarding the game business, our games are mostly high daily active users (DAU) and long engagement games, with relatively low average revenue per user (ARPU), making them more resilient in the macro environment. In contrast, games with low DAU but high ARPU may be more affected, but these are not Tencent games. Overall, innovation is the main driver of growth in the gaming industry, and even in challenging macro environments, continued innovation can drive market expansion.

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