Tencent (00700) 2023 Q3 financial report conference call: There is still significant growth potential in video ad revenue, and the chip inventory is sufficient to continue the development of the Hybrid Grand Model for several generations.

On November 15th, Tencent (00700) announced during its third-quarter 2023 earnings conference call that the usage of Video Accounts is growing rapidly. Video Accounts have increased the overall usage time of WeChat, and they are also generating revenue at a higher rate than Tencent's average. With Tencent continuing to deploy artificial intelligence technology to improve ad click-through rates, there is still significant room for growth in advertising revenue for Video Accounts. In addition, the company has a considerable inventory of H800 chips, enough to continue developing multiple generations of Mixin, and the company will also explore domestic chip suppliers for certain chips. The financial report shows that Tencent achieved an operating profit (non-IFRS) of 55.483 billion yuan in the third quarter, a year-on-year increase of 36% and a quarter-on-quarter increase of 11%. Net profit was 44.92 billion yuan, a year-on-year increase of 39% and a quarter-on-quarter increase of 20%, surpassing market expectations of 39.98 billion yuan. Tencent President, Liu Chiping, stated that Tencent has entered a high-quality revenue growth mode, in which Tencent can provide greater operating leverage than before. Regarding gaming, Liu Chiping stated that Tencent has observed an increasing interest in casual games among people, as well as a renewed interest in narrative-based games. Although this trend has not had a negative impact on Tencent's multiplayer competitive games, Tencent also believes that this trend is a new opportunity that can be seized, and they are investing in these trends to benefit from them. For enterprise services, Tencent Chief Strategy Officer James Mitchell stated that Tencent's enterprise service revenue grew at a double-digit rate year-on-year in the third quarter, with an accelerated growth rate compared to the second quarter, and the gross margin of the enterprise services significantly improved. The growth of cloud service revenue has benefited from the previous restructuring, as well as increased spending from industries such as finance and automotive. Video Account and e-commerce transaction GMV have seen quarter-on-quarter growth, along with the technology service fees Tencent collects from these transactions. Additionally, Tencent has upgraded its proprietary base model, Tencent Mixin. Through mini-programs, Mixin Siasun Robot&Automation was initially provided to a growing number of small-scale users. Externally, Tencent provides APIs or models to enterprise customers as cloud service solutions to leverage the capabilities of Mixin's large-scale language models, enabling features such as encoding data analysis and automated customer service. Below is an excerpt from the conference call: Q1: Could management share with us the future development strategy of mini-games? Will there be any changes in the game publishing strategy between program games and mini-games? For mini-games, we see the opportunity mainly as a platform opportunity for Tencent. There are now thousands of game development studios that can focus on making mini-games. We are happy to nurture this ecosystem and we do not want to squeeze or put pressure on this ecosystem. As for whether we will revitalize existing games in their product lifecycles through the release of mini-games, the reality is that Tencent's game strategy is not built around those games with aging product lifecycles that require substantial updates. Tencent's game strategy revolves around content that is meant to become evergreen games, aiming to make those evergreen games as successful and popular as possible, and then adding more similarly successful and popular evergreen games. Tencent is not very concerned about small games with product lifecycles and then reviving them through mini-games or other means. Q2: How will the U.S. chip expenditure bill affect Tencent's artificial intelligence strategy, including product launches, monetization, and priority areas? Regarding Mixin and the overall artificial intelligence strategy, we have come a long way in building Mixin. We believe Tencent is one of the leaders in AI in China, and we are continually expanding the scale of the model and preparing for our next-generation Mixin model, which will be a hybrid of expert architectures. We believe this will further enhance the performance of our Mixin model. By building Mixin, Tencent has effectively established capabilities in general artificial intelligence because Mixin, which is based on the Transformer model, involves a large amount of data, training data, large-scale computing clusters, and processing of large-scale computations. Mixin has become very skilled in generating text and messages, which is actually very useful for many SaaS applications, as it can enhance the capabilities of SaaS services. For example, in Tencent Meeting, we can actually use Mixin to write meeting summaries, helping people who missed the first half of the meeting understand the meeting content, and so on. Targeted documents can provide people with a helpful tool to create documents more efficiently and provide services to help advertisers create more targeted ads, thus improving ad click-through rates. It can also improve the quality of art-related content creation in the game production process. In short videos, by enhancing our AI capabilities, we can actually increase the user base at a faster pace. In terms of advertising business, by improving targeting capabilities, we have effectively increased ad revenue and provided better results for our clients. For our clients, who are generating more content, our AI capabilities are producing tangible results at this time. Mixin can actually provide many tools for enterprise customers, and it can further improve the efficiency of our advertising business in the future, truly integrating the advertising phase with the sales phase. If we can truly provide excellent customer service capabilities, many merchants can actually merge advertising and sales processes. We also believe that in the future, with a consumer-oriented product that is more like people's intelligent agent, there is actually great room for imagination. Regarding the U.S. sanctions, in terms of the current chip situation, we are actually in a good position.The company is one of the Chinese manufacturers with the largest inventory of artificial intelligence chips. Tencent was the first company to order the Nvidia H800, which has allowed us to have a considerable stock of H800 chips. Therefore, we have enough chips to continue developing the mixed reality technology for at least several generations.Therefore, the ban did not really affect the development of Hyunyuan and our short-term AI capabilities. However, we do believe that it did impact our ability to resell these AI chips to the entire cloud service industry. So this is an area that could be affected in the future, and we will need to find ways to make the use of our AI chips more effective. We will try to see if we can use lower-performance chips for a large number of inference tasks, so that we can keep most of the high-performance AI chips for AI training. We will also try to find domestic suppliers for these chips. Q3: Regarding the game business, Tencent determined two years ago that games are a key investment area for future growth, and at that time, Tencent expected a production cycle of about 2 to 3 years. With the improvement in financial performance, Tencent now has more time to work on longer production cycle projects. So what is the current production cycle for Tencent? How should we view the conversion of these investments in the development pipeline of different types of games and the financial performance in the next few years? For the game-related question, overall, we have chosen to sometimes extend our game production cycle by 6 months, sometimes by 18 months. There are a few reasons for this. First, it has been proven that the best games have a better chance, especially if the development studios are willing to invest time and resources to let the best games reach their fullest potential. And of course, we want to seize that and release the best games. With a high-quality revenue growth model already established, we feel that we now have more flexibility. With the existence of Video Account, mini games, search, and e-commerce, we are able to maintain a quite healthy revenue growth rate even in a given quarter without releasing any major games. So considering these two points, we think it makes sense for us to have a longer-term focus and truly concentrate on maximizing the potential of the games in development. Currently, we have nine games in the pipeline, and one of them will be released in the next few weeks. Other games will be released in the next few months. These games will serve as test cases for how our execution in this direction is working. But overall, we think that now we have that flexibility to have a longer-term focus, and because high-quality revenue growth model has already been established, Tencent has the ability to achieve revenue growth even without releasing games in a quarter. Q4: Tencent increased dividends last year and also increased stock repurchases. How should we view the opportunities in Tencent's investment portfolio? In terms of shareholder returns and capital management, first of all, Tencent is very focused on shareholder returns, and we will try different ways to enhance investment returns. And secondly, Tencent has very strong cash flow and a very large investment portfolio, of which half is actually in liquid stocks. So Tencent will flexibly use different tools to increase shareholder returns, such as buybacks, dividends, and the investor return programs we have done before, as well as divestitures to get cash so that we can do more stock repurchases and distribute dividends. We will dynamically use these tools and enhance shareholder returns and return capital to shareholders with different combinations at different times. And given that the valuation of Chinese internet stocks has almost reached historically low levels, stock repurchases could be a more favorable means for Tencent's shareholders compared to other methods. Q5: Regarding the sustainability of the improvement in gross margin in key advertising and fintech areas in Tencent's investment portfolio, can the revenues seen so far continue beyond 2024? Is there further room for improvement? And regarding the fluctuating gross margin of domestic games in recent years, Tencent seems to have assimilated the impacts of epidemic prevention and control and piracy, entering a relatively normal period. How should we think about the medium and long-term growth mode in this field? To what extent does it rely on new popular content? On the gross margin issue, we have talked about the three drivers that have improved our profitability in the past few quarters, and two of them we believe have sustainable and recurring characteristics, while one, like personnel adjustments and restructurings, is more occasional. Overall, the fastest growing revenue stream in our business is also the one with the highest profit margin. So we believe the current gross margin level is sustainable, and we believe there is room for further improvement in profitability. For example, the gross margin of our advertising business has increased from around 30% to about 50%, while the advertising gross margin of our closest global peer is around 80%. Regarding the game business, we believe the existing evergreen games provide a certain amount of growth. And in addition to that, we have a pipeline of new games in the works. Depending on the timing of our new game releases and the success of these new games, they can provide additional growth. Q6: When Tencent's games enter the international market, can you provide more details on what further investments Tencent needs to make when continuing to invest? For example, Call of Duty Mobile, although it has been launched for four years, Tencent achieved record-breaking performance in July. So how to extend or revive the popularity of existing games while balancing the release of new games? Another question is about capital expenditure and personnel plans. Tencent had higher capital expenditure this quarter, and there also seems to be gradual improvement in the size of the workforce. Can you share some relevant information? Tencent has made significant investments in overseas games. And of course, we have large studios in China, such as Timmy and Quantum, with thousands of developers who are developing games for both the international and domestic markets. So we believe we now have the teams to create high-budget, high production-value games for the international market that can ultimately succeed. We will release these games in the coming quarters. In terms of operating capital expenditure, it is expected to account for about 3% to 5% of total revenue in 2023 and is expected to remain at a similar level in 2024, around 3% to 3.5%. If we can obtain more graphics processing units (GPUs), it would add an additional 1%. Non-operating capital expenditure is expected to be around 1% to 1.5% annually. In terms of construction, in the past few years, our capital expenditure has focused more on improving infrastructure and the establishment of our base.It costs about 1 billion dollars each year, not including any land acquisition costs. If land acquisition costs are added, the additional expenses should not exceed 1 billion dollars. we are gradually building everything within our ecosystem. Once we achieve this, we can now allow people to search on the open internet. We also have unique content exclusive to WeChat. This will enhance the value proposition and content of WeChat search. Take on too much risk, and we can also choose to serve the highest quality customers. In the long run, we actually hope to find more value-added services to bring value to the merchants we serve. If we truly create value, we will charge some additional fees.As far as cloud business services are concerned, the industry has undergone significant capacity adjustments and the available capacity has been fully utilized in the past two years. Many companies have been actively striving to reduce costs. We have also actively phased out some low-quality business. As we look ahead to 2024, we believe that the squeeze on unused capacity in the market may have come to an end. So if the macroeconomic conditions remain unchanged, there may be some moderate growth in cloud usage, but higher economic growth may be needed to bring about higher growth rates. Regarding PaaS and SaaS, there may be some growth, which is actually the area of our focus. We believe that in the future, we will be more focused on high-quality revenue models and will pay more attention to the PaaS and SaaS fields. Therefore, fundamentally, this will bring us more gross profit. Q15: How should we view investment and reinvestment in the portfolio this year, as well as any experiences and lessons learned in investment allocation over the past two years? How should shareholder returns be considered at the front end of the investment portfolio? Regarding the portfolio, we are very proactive and flexible in increasing investment and divestment. While some activities are visible, many activities are invisible. However, considering that we believe there are mispricings in the stock price, the primary use of cash is to repurchase our own stocks, which remains the top priority at present.