TENCENT (00700): Accelerating investment, slowing down profits, can the stock king still be "both offensive and defensive"?

Tencent (00700) released its financial results for the third quarter of 2024 after the Hong Kong stock market closed on November 13th Beijing time. Despite the impressive performance on the profit statement, it did not exceed expectations. It can only be said that in the macro environment of the third quarter, it is very difficult for the stock king to beat high expectations solidly! Specifically, the key points are as follows: 1. Sorting out expectations and logical lines: What is the market trading Tencent for? Before discussing the financial report, let's first briefly discuss the current trading logic, priced-in logic, and expected up/down risks for Tencent: Tencent's three main money-making areas, games, advertising, and fintech, are expected to perform in the order of "games > advertising > fintech" by the end of this year from a short-term perspective. The market's trading logic can be divided into two periods: 1) Before September 24th, the trading logic for Tencent was defensive: "Games rebounding + advertising with relative alpha (video accounts, mini-game apps) + continued cost reduction and efficiency improvement + high shareholder returns (billion-dollar buyback + continuous dividends)", and offsetting the weakness of fintech (WeChat Pay entered the Taobao e-commerce ecosystem in September, providing some offset to the current weakness). 2) After September 24th, the market trades with an "offensive logic". Although Tencent's stock price has rebounded, the rebound strength is not as high as cyclically sensitive e-commerce stocks, consumer stocks, and active small-cap stocks. One of the dilemmas is that on one hand, the previous adjustment was not large, and on the other hand, Tencent's games are gradually moving past the peak of this product cycle. For example, "DnFM" has gradually slid out of the top 5 best-selling games. Although Tencent also has two areas of success, advertising and fintech, foreign funds are not eager to enter these areas of potential positive expectations until they see real pro-people policies being implemented. Therefore, it is possible that the biggest expectation gap in the short to medium term lies in whether the policy side will eventually take action. 2. So does the Q3 performance change the above trading logic? (1) Profit seems impressive but is actually average Adjusted net profit for the third quarter was 59.8 billion, higher than the market's expectation of 54.4 billion, but it did not actually exceed expectations. The main reasons are the difference in the contribution from joint ventures and effective tax rates compared to market expectations. Simply put, if we only look at the operating profit of the core business under GAAP, it was 50.4 billion in the 3rd quarter, actually lower than the market's expected 52.3 billion. (2) Revenue pressure on the market has already been fully expected Regarding the performance of individual businesses, the third quarter largely confirmed the market's consistent expectations: strong games, neutral advertising, and challenging fintech. From the perspective of expectations and outlook, it is highly likely that the high growth in games can continue into Q4. However, it is undeniable that the easiest quarter for high revenue in "DnFM" has passed, and if there are no surprises, it cannot avoid the gradual decline in revenue under normal product lifecycle processes. However, "DnFM" is not an ordinary game, and it still has the potential to become a new member of Tencent's long-term game success through high-quality operational means. From an investment perspective, we are not making overly positive long-term assumptions at the moment; a consideration of expectations according to the normal revenue decline can be made. Although advertising still has relatively high incremental effects such as video accounts and mini-game apps in the third quarter, these effects are gradually diminishing. Q4 has an e-commerce festival which is expected to perform fairly well, but as Tencent passes the low base year this year, next year its advertising may also begin to feel the macroeconomic chill. As advertising and fintech businesses start to be significantly affected by macro factors, dependence on future pro-people policies will become more evident. Overall, institutions have rather fully expected growth pressure on the revenue side. This is especially evident in the expectations for fintech business, which has seen a month-long process of downward adjustments by institutions. The only minor difference is in overseas game revenue, where the market expected a year-on-year growth rate of around 15%, but the actual rate was only 9%. However, the company explained that some games have high retention rates, so they proactively extended the deferred period, resulting in a revenue growth rate higher than 9%. The Dolphin feedback is relatively positive for this explanation, as high retention rates indicate a longer game lifecycle, which, although affecting short-term revenue recognition, actually contributes more total value to Tencent. (3) Restarting investment expansion cycle? Dolphin added a question mark, as we need to confirm this based on the conference call. Tencent's three operating expenses increased positively in the third quarter, with promotional expenses and research and development expenditures showing significant growth. The increase in promotional expenses is related to the intensive launch of new games, and a breakdown of research and development expenses shows that server bandwidth growth is higher than staff salaries. In addition, capital expenditure increased to 12 billion this quarter, leading us to speculate that it is likely to be related to investments in AI. At the same time, the total number of employees in the group increased by 3300 compared to the previous quarter, indicating a renewed expansion trend in the third quarter compared to the past two years. This has actually taken the Dolphin by surprise because although management mentioned in the previous two quarterly conference calls that they would actively invest in areas of interest (such as AI, overseas games, video accounts), the sudden increase in staff numbers is somewhat exaggerated, and it contradicts recent news reports of layoffs among high-level game executives. It is reasonable to speculate whether these are mainly new graduates entering the workforce or perhaps Tencent has some social responsibilities in terms of employment. However, in addition to the increase in staff numbers, average compensation per person also increased compared to the previous quarter, which may also be influenced by bonuses from "DnFM" mobile gaming. Let's wait for the management's explanation during the conference call for more details.See if it is just a short-term disturbance, while the overall direction of reducing costs and increasing efficiency remains unchanged. However, if the stock king truly re-enters an expansion cycle, maintaining the growth level of profits will undoubtedly transfer growth pressure to the revenue side.Short-term concerns, but no doubt about long-term profit potential If the implementation of people's livelihood policies is not strong enough, short-term effects are not good, and as the environment continues to deteriorate with the gradual depletion of the growth dividends from games and advertisements, the market will undoubtedly become more stringent on the expenditure side. Tencent's actions to restart investments will also become more conspicuous. However, the Dolphin believes that short-term games and policy implementation are unavoidable. Due to the high uncertainty in time and scale, short-term games have little significance. Taking a long-term perspective, the Dolphin has always believed that Tencent has a high leveraged releasing capacity. This is reflected not only in the optimization of the organization with over 100,000 people (the manpower ratio of mature businesses is not high), but also in the interconnection between various businesses upstream and downstream within the same industry chain, reducing the friction costs at the group level and thereby enhancing overall efficiency. 5. Shareholder Returns: Emotional outbursts after September 24, buybacks decreased in accordance The overall net cash (cash + deposits - long and short-term interest-bearing debts) of the group in the third quarter was 95.4 billion, an increase of over 20 billion from the previous quarter. On one hand, the warming up of games brought in a higher current cash flow, even with an increase in capital expenditure, the free cash flow increased by nearly 18 billion. On the other hand, after the September 24 policy, buybacks decreased by 15 billion compared to the previous quarter. Currently, repurchased shares have been cancelled. By the end of the third quarter, the group's total shares decreased by 0.9% compared to the previous quarter. The market's positive view of Tencent is one of the core logics for the market so far this year. If the buyback and dividend plan is achieved according to plan, the shareholder returns would be 4% compared to the current market value of 3.7 trillion HKD. However, if the buyback intensity and pace are restored to the level before September 24, the shareholder returns would still be over 5%. With abundant cash flow and net cash reserves, there are various possibilities for a further increase in buybacks. Therefore, the Dolphin believes that, even in the face of a challenging macro environment, Tencent can still benefit from its investment advantages. However, major shareholders are still quietly reducing their holdings. From August 14, as of yesterday, November 12, Prosus sold 34 million shares in the past 3 months, a slight decrease compared to the average monthly sell-off pace in the previous period (or possibly due to market closure on typhoon days). But because Tencent's buyback cancellation intensity has always been greater than the sell-off (a net decrease of 41.38 million shares from August to November), as of the end of the third quarter, the change in the proportion of major shareholders' holdings has not changed much, remaining at 24.1%, a decrease of only 0.25% from the previous quarter. 6. Detailed financial data overview Dolphin's view Earlier in the text, the Dolphin detailed the short-term trading logic and third-quarter performance. Simply from the perspective of performance vs. expectations, it is clear that the performance of the stock king is difficult to satisfy the market, especially with the impact of the restart of investment cycle on the pace of short-term profit recovery. However, the recent adjustment also indicates that negative market expectations are continuously being priced in. Therefore, to evaluate Tencent's third-quarter performance more comprehensively, it is necessary to consider valuation. The non-IFRS net profit in the third quarter exceeded expectations, driven by the contribution of Tencent's associated companies to profits, as well as a reduction in the effective tax rate. The former depends on the operational performance of associated companies, in the short term, various companies are focused on reducing costs and increasing efficiency to improve profitability, so the Dolphin expects this positive trend to be sustainable in the "short term". The change in the effective tax rate is not a coincidence. Due to deferred taxes overseas last year, the effective tax rate was high, but this is not a stable state. Therefore, the decline in the effective tax rate in Q3 can be seen as a "medium to long-term" stable trend. Therefore, from the perspective of the overall group, Tencent's ability to make money has not decreased. According to valuation based on the overall EV/Non-IFRS NP, the current market value of 3.7 trillion HKD implies a valuation of 14x based on the expected profit of 240 billion RMB for 2025 (without excluding net cash), which is relatively low from both a historical perspective and a long-term growth (profit CAGR +10-15%) + premium logic (PEG>1). Although the short-term restart of expansion raises concerns about profit pressure, and there is still uncertainty in the implementation of policy games, from a medium to long-term perspective, the Dolphin believes that Tencent, with its strong barriers, has the ability to adjust profits against the trend and may achieve similar results in AI-driven advertising as Meta. Therefore, we believe that funds that avoid short-term expectations due to concerns about missing expectations may return after the sentiment of performance realization is digested. With a relatively controlled investment expansion in new areas, the stock king still has the potential to recover from 14x to a neutral valuation of 16x (+15%). Of course, future people's livelihood policies are still crucial. If the policies are positive, then the logic to support Tencent in advertising and cyclical industries, aiming for a 16x valuation would be feasible, or even reaching a level close to global internet giants with a valuation of 20x. On the other hand, if the short-term policy actions are minimal and macro pressures continue to dominate, Tencent may still become a core target for "hold and defend" based on "high shareholder returns and high competitive barriers". Although the expectations from conservative to optimistic, Dolphin's assumptions about valuation expectations and the flexibility are different from some growth stocks and speculative small caps, but if seeking a relatively stable return under the first requirement of certainty, the stock king is still a good choice. The following is a detailed analysis I. User ecosystem: WeChat stable growth, while QQ declines again In the third quarter, WeChat users were 1.382 billion, with a net increase of 11 million, exceeding expectations for stable expansion. After stagnation for a quarter, QQ actually lost 9 million users during the peak summer season in the third quarter. Stable traffic can support the deepening commercialization of the WeChat ecosystem, while changes in QQ need to be further observed to see if it is just a short-term fluctuation. However, as young users gradually integrate into WeChat, it is difficult to change the long-term shrinkage trend of QQ. Value-added service paying users saw a slight rebound in Q3, with a net increase of 2 million, offsetting the decline in paying users for live streams. Despite the increase in users, Tencent did not make many additional investments in content in the third quarter, and media content costs increased year on year.Only 1.7%. However, from the trend, there seems to be signs of a new investment cycle approaching. Subsequent tracking and observation will continue. II. Gaming: Is Q3 the peak of this round of the cycle, which is warming up as scheduled? In the third quarter, the revenue from online games reached 51.8 billion yuan, an increase of 12.5% year-on-year, driven by the contribution of DNFM for the entire third quarter, leading to the warming up of revenue as scheduled. However, in terms of performance, both domestically and internationally, the market had higher expectations for overseas revenue, with a year-on-year growth rate of 15%. But in reality, the growth rate of overseas games was only 9%. The company explained that the high retention rate of some games led to an extension of the deferral period, and the actual revenue growth rate was higher than 9%. In response to this explanation, Dolphin Jun feedbacked relatively positively. A high retention rate indicates that the game's lifecycle will be longer, although it affects the recognition of short-term revenue, it actually contributes higher total value to Tencent. The growth of the domestic market increased by 14%, finally returning to double-digit growth after three years but not exceeding expectations. The growth momentum mainly came from new games, with major titles being "Dungeon & Warrior Mobile," "Fearless Contract," and "Delta Force." Among older games, "Peace Elite" increased commercialization during the summer, continuing the improvement seen in the second quarter, thereby contributing to the growth of domestic games in the third quarter. The growth of overseas games was 9%, with games like "PUBG MOBILE" and "Wild Combat." In the third quarter, "VALORANT" expanded to the PS and Xbox platforms, achieving a year-on-year growth of over 30% and contributing significantly to the increase. Revenue indicators calculated in combination with deferred income represent forward-looking indicators that can better reflect actual demand. Deferred income in the third quarter increased by 20% year-on-year and remained stable quarter-on-quarter. Why did deferred income in the third quarter not reflect the high activity characteristics of users during the summer peak season? Dolphin Jun believes that there are mainly two reasons for this. First, although new games performed well, super-head games like "King of Glory" did not perform well during the summer. Sensor Tower data shows a decline in revenue on the iOS platform of "King of Glory" of 5-10% from July to September. Second, the high activity of users during the summer led to immediate spending on purchases. The overall increase in value-added services revenue in the third quarter was 3%, in line with normal seasonal trends from previous years. Therefore, based on this, it is expected that games will continue to grow in the fourth quarter with the base of last year. However, it must be acknowledged that as the year-end approaches, the peak period has already passed. Looking at the pipeline, apart from postponed games like "The Awakening of Stars," "Luo Kingdom Mobile," and the heavyweight IP "King of Glory World," other games have limited potential to boost the gaming market of over 500 billion yuan. Tencent will need to continuously activate old games through excellent operation methods, especially for "DNFM," which just launched this year and is expected to become a new member of Tencent's evergreen tree games. In the industry, the third quarter was particularly turbulent. The overall growth rate of the gaming market in the third quarter rose to 8.9%, but the growth rate of mobile games was only 1.2%. With hundreds of mobile games vying for the summer spotlight, it ultimately turned out to be a zero-sum game, with some companies happy and others worried. For top players, even though the new game "Zero Zone" was popular domestically and internationally, Xiaomi is estimated to be less happy because its own second-class "Genshin Impact" did not perform well during the summer. Of course, the overseas market is generally larger, and not all domestic game companies have the strength to go global. Therefore, the overseas revenue growth of domestic games in the third quarter showed a significant increase of 20%. However, for Tencent, there weren't many new products in the third quarter for overseas markets, mainly focusing on the "King of Glory International Edition" and "Fearless Contract." Therefore, even with a revenue growth rate higher than 9%, it is expected to be relatively lower than the industry average. III. How long can advertising sustain its alpha? We all know that in the past two years, with the rise of video accounts and mini-program games, Tencent faced adversity but maintained alpha logic in its advertising business. However, as the digital effects of low base numbers weaken, even with video accounts and mini-programs, it's becoming increasingly difficult to withstand the growing environmental challenges. Therefore, although Tencent's advertising revenue growth rate in the third quarter was 16.6%, matching market expectations, the market is concerned about the pressure that lies ahead. In the third quarter, growth is expected to be mainly driven by social advertising (within WeChat). Among them, the new advertising growth points in the third quarter were WeChat Mini Shops and WeChat Search. The WeChat Mini Shops, launched in the third quarter (upgraded from "Video Account Mini Shops"), leverage the large traffic scale, high user engagement, and active interaction of WeChat, providing businesses with more traffic and transaction support, thus enhancing the commercialization capabilities of the WeChat ecosystem. Meanwhile, WeChat Search achieved year-on-year growth in commercial search volume and click-through rate in the third quarter. By the way, various platforms have integrated internal search functions, such as Douyin, Xiaohongshu, and Kuaishou. WeChat Search has been continuously feeding traffic and cultivating user habits since its launch in recent years. Rough estimates by Dolphin Jun suggest that, excluding the impact of video accounts (estimated at 70-80 billion yuan for external circulation + e-commerce advertising, with a year-on-year growth of 60-70%), traditional advertising revenue growth is also expected to be in the mid-single digits. Furthermore, media advertising may have slowed down growth due to macroeconomic pressures. Apart from Tencent News having a large amount of information flow advertising, other platforms mostly have brand advertising, which tends to lag behind during macroeconomic pressure periods. IV. Financial Technology: Payment Pressure In the third quarter, Tencent's financial technology grew by 2% year-on-year, slightly below market expectations, but analysts have been continuously lowering their expectations over the past month. Before further easing financial regulations, Tencent is unlikely to prioritize promoting internet microloans (split payments & installments) and internet insurance as value-added financial services. Therefore, the current mainstay of Tencent's financial technology business is still payments (accounting for 90% of financial technology and 70% of financial enterprises). Given the already high market share of payments, it is essentially a strong pro-cyclical logic. Hence, in a macroeconomic environment that was unusually weak in the third quarter, it was basically unavoidable for the financial technology business to slow down. Under macroeconomic pressures, offline payment industries further slowed down. Coupled with the high base effect from the demand surge following the end of the epidemic last year, it is challenging for the financial technology business to maintain growth in the third quarter.Payment institution reserves dropped significantly year-on-year. In its financial report, the company also disclosed that WeChat Pay revenue in the third quarter began to decline year-on-year.In September, WeChat Pay announced that it has been included as one of the payment methods on Taobao. Although it has been hidden in a less prominent position and may not have a significant impact in the short term, with WeChat's dominance in consumer scenarios, it is expected to naturally penetrate more market share within the Taobao system. Market expectations suggest that if WeChat Pay's transaction GMV reaches 20% in the Taobao ecosystem, it could mean an additional annual revenue of 6 billion. Despite the sluggishness in payment, the incremental revenue in the third quarter still came from commissions from video accounts and cloud services (enterprise WeChat commercialization). Excluding the predicted 1.5 billion in revenue from video account commissions, there is implied single-digit growth in cloud services. However, compared to the previous two quarters, there is a noticeable slowdown. Regarding investment gains, based on the original definition, we mainly look at other net income (including investment income), and the share of profits from associated/affiliated companies: 1) Other net income was 6.14 billion, showing a significant increase from the previous quarter, mainly due to the increase in fair value of certain assets and asset disposal gains. In the third quarter, there was still 2.4 billion in asset disposal gains, indicating Tencent's ongoing optimization of its investment portfolio. Combining this with the company's earlier statement that the necessary funds for the investment portfolio have been internally resolved earlier in the year, signaling that they won't rely on external funds beyond their investment business. With pressure for repurchasing and continued investments in AI and other new technologies, Tencent may continue to maintain higher levels of investment gains compared to last year. 2) Profits from associated/affiliated companies in the third quarter were 6.019 billion, mainly reflecting the profits of Tencent's non-controlling investments in brother companies. However, this profit in the third quarter has decreased compared to last year, reflecting the operational pressures faced by the invested companies due to the broader economic environment. Additionally, Tencent's financial reports are usually released before those of the invested companies, so this data does not entirely represent the actual profits of the invested companies. Tencent will estimate the profits based on the data collected and adjust for seasonal differences to reflect the actual profits of the invested companies. As of the end of the third quarter, the combined assets of the jointly/affiliated companies totaled 273.2 billion, and with profits amounting to 6 billion, Tencent's investment yield for the third quarter was 2.2%, showing a slight decrease from the previous quarter. Could this be the start of a new investment cycle for Tencent?