Ep. 19: Tencent and the Case of the Missing $140B

So far in 2018, Tencent’s stock price has continued to tumble from analysts’ price targets. Today, it sits at $430B, a far cry from its $570B market cap in January, and having done far worse than the market. Some commentators blame the decline on Tencent’s Q2 results, which showed a 2 percent drop in earnings and was the company’s first fall in profit in nearly 13 years. What is really going on here? What is the real cause, and what does it all mean for what is arguably still China’s leading internet company?

In this episode of TechBuzz China, co-hosts Ying-Ying Lu and Rui Ma take another close look at Tencent. TechBuzz first covered Tencent in Episode 5, and again in Episode 9. Fittingly, those episodes focused on public perception of Tencent’s ability to innovate, as well as the robustness of Tencent’s overall strategy – including against the likes of rising behemoth Toutiao. This week’s Ep. 19 takes a more holistic view of the internal and external factors that may have contributed to Tencent’s poor results. Listeners will also hear expert commentary by Lee Gao, Portfolio Manager at GCA, who helps run the firm’s Emerging Markets Sustainable Growth Fund.

Rui and Ying-Ying delve into many facets of the Tencent story, including: What was the significance of COO Mark Ren taking over the company’s stalwart gaming sector, which accounts for over 50 percent of Tencent’s revenues? What has been the greater impact of Tencent’s protocol of having multiple internal teams work on the same product, with the best one declared winner? How has this type of strategy, and its accompanying lack of deep data integration, affected Tencent’s domestic market share on metrics such as total mobile usage time, as well as its ability to collaborate deeply with partners such as Starbucks? What about the impact of other problems such unfavorable government policies, as well as Tencent’s challenges getting games approved to be distributed in China?

Listen to the newest episode of TechBuzz China and join our co-hosts on a journey down the rabbit hole, as they hunt for the real cause of Tencent’s recent price decline. As they synthesize the rampant recent speculation by Chinese media into a mere 20-minute episode, listeners are left to ask themselves: can Tencent do it? Can they bring the lost $140B back?

As always, you can find these stories and more at http://pandaily.com/. Let us know what you think of the show by leaving us an iTunes review, like our Facebook page, and don’t forget to tweet at us at @techbuzzchina to win some swag!

Full Transcript

We are TechBuzz China by Pandaily, powered by the Sinica Podcast Network.
We are a new weekly podcast focused on giving you a peek into what’s buzzing within the tech community in China. We uncover and contextualize unique insights, perspectives and takeaways on headline tech news that don’t always make it into English language coverage. TechBuzz China is a part of Pandaily.com, a new English language site that tells you “everything about China’s innovation.”

(Y: Ying-Ying Lu; R: Rui Ma; L: Lee Gao)

[0:01] R: We’ve done a few episodes on Tencent now. I mean, it was actually the subject of our very first longform episode. Remember when we used to try to cram in two stories per episode? But then we produced Episode 5: Has Tencent lost its mojo and loved that so much we’ve been sticking to one in-depth story every time.
Y: Right. If you haven’t listened to that one, you really should, because it gives a ton of background on how Tencent has changed over the years, especially the last five years. Hint: it wasn’t always viewed with the same benign and high regard that it commands today. There was a core strategic shift the reverberations of which are being felt right now, or so many people think.

[0:45] R: I should also point listeners to Episode 9, which was on Tencent’s war with Toutiao also known as Bytedance. It’s also a key reason for Tencent’s slump this year, and actually, tha’s what we are going to talk about today. It seems like just yesterday that we were celebrating both Alibaba and Tencent exceeding half a trillion dollars in market cap. That’s not so much the case anymore, not for Tencent anyway.
Y: Yup. Tencent accomplished that feat last November, and Alibaba followed two months later. But less than a year later, Tencent finds itself with a stock price of 354HKD, or only about $430 billion in market cap. That’s still very respectable, obviously, but It’s a far cry from the $570 billion market cap that it had just in January.

[1:36] R: Of course, let’s not diminish the greater macro market conditions, too. US tech stocks, FAANG, or Facebook Amazon Apple Netflix and Google have done actually pretty well, with only Facebook down for the year, the Hang Seng Index, indicator for the Hong Kong stock exchange where Tencent and now Xiaomi are both listed, is actually down almost 10% for the year.
Y: Sure. But even taking that into account, Tencent has done far worse than the market. $140 billion of market value is wiped out, or a 25% drop from its peak. I mean, that’s like ten snapchats, six twitters, or three JDs. What happened here? Let’s find out.

[3:17] Y: Shoutout to our fans Paul Waide, Justin Wei, and Lee Gao, who you’ll actually hear from later this episode, and to all those who continue to give constructive feedback.
R: If you enjoy listening to us, please take the time to leave us a rating or review on iTunes, Facebook or wherever you get your podcasts!

[3:42] R: Let’s review. Back in April, just barely over one quarter ago, the 45 analysts who rated Tencent, according to FactSet, still gave it a target price of $523 HKD. Now you ask: what does that mean? It means that they were expecting it to get to a market cap of about $630 billion.
Y: Obviously, that wasn’t actually what happened, as we are now $200 billion away from that target price. Well what did happen? A lot of people are blaming it on Tencent’s Q2 results, when they announced a 2% drop in earnings and lagged behind consensus estimates for revenue as well. It was the first fall in profit in nearly 13 years.

[4:32] R: Were Tencent’s results so bad though? Not if you look at it in isolation. Q2 2018 revenues grew 30% year on year. Operating margin did go down a lot, from 40% to 30%. Net margin similarly decreased from 32% to 25%, but that still means for Q2 2018, Tencent made $2.7 billion! For perspective, it’s usually somewhere between Alibaba and Facebook, two other companies around the half-trillion dollar market cap range.
Y: But it is bad if you look at its gaming results. And in China, Tencent has been equated with gaming. If you’re in gaming, chances are you’ve heard of Mark Ren and the three 50%s, 三个百分之五十, that describe his importance and status in the industry, the percentage being – number one, gaming revenues account for more than 50% of Tencent revenues, it also has over 50% market share in China, and has profit margins of over 50%.

[5:34] R: And for the most part, he has held onto them. In 2017, Tencent had total revenues of about $35 billion, and of those, according to market research Newzoo, $18 billion were from games, so I guess that’s over 50%, right? You know what else was $35 billion? China’s entire video game market, according to Statista anyway. Tencent’s gaming revenues is almost double second place Sony, and three times as much as sixth place Netease. In gaming, Tencent is absolutely the 800-pound gorilla in the room. Globally.

[6:10] Y: And it’s all due to Mark Ren, or 任宇昕. He joined Tencent in 2000 as one of its first employees and was promoted to COO in 2012. Mark now leads 4 out of Tencent’s 7 business groups, the Interactive Entertainment Group, Mobile Internet Group, Social Network Group, and Online Media Group, which has my favorite abbreviation of OMG. Anyway, that’s basically everything at Tencent because all that’s left are the Corporate Development Group and the WeChat Group, which we all know is separately managed by Allen Zhang. The last group is Technology and Engineering, which is R&D and operations.

[6:46] R: Mark is a cool dude. He’s made some non-obvious choices in his career. After graduating college in 1998, he joined Huawei as an engineer. At that time, Huawei wasn’t nearly as big at the time as it is today, but still it was a risky move to join itty bitty Tencent. At Tencent he wanted to take on engineering challenges. However, Tencent co-founder Tony Zhang felt that his other significant talents would be wasted and refused to let him join the QQ servers team.
Y: Or maybe he just wasn’t a good engineer and Tony was too polite to tell him. Kidding, let’s uphold the urban legend. Anyway, as Mark did more management, he was faced with a choice in 2003 or so, to join the Value Added Services team, which at the time mostly consisted of telco projects, and made up the bulk of Tencent’s revenues at the time, or join the newer Gaming division. Ever the risk taker, he decided to go for the latter.

[7:45] R: Well, I know what you’re thinking, but it wasn’t quite as simple as, let’s pick the smaller and more nimble team where I can make a bigger impact. Actually the gaming team at that time had actually just gone through layoffs and it was a dismal place to be. It wasn’t just starting from zero, it was like starting from negative. And for the first two years, Mark really struggled. Tencent gaming was consistently first and second place … from the bottom.
Y: But when you’re that low, there’s nowhere to go but up right? In 2005, Mark’s group was ranked No.8 in the industry in China. And we know where it is now. In the just reported Q2 results, Games brought in $3.7 billion of revenue, up 6% year on year. Yes, that’s just game alone. But investors were likely disappointed because in the past three years the entire market has been growing 20% annually.

[8:46] R: In Tencent’s defense though, the market is actually expected to slow down significantly this year to just 5%. But don’t let that measly 5% fool you. China is still a huge and hugely profitable market. Here are a few stats by the way that might astound you. For example, even at such low growth, the Chinese gaming market is gonna be nearly $38 billion this year, far ahead of the No.2 market, the United States which is only about $30 billion. There are also over 600 million gamers in China, that’s almost half the population. 60% of the revenues will be coming from mobile. What is really crazy though is that for urban players, that’s those in Tier 1 and Tier 2 cities of China, 94% of them have bought in-game items in the last 6 months. What?? No wonder when I play against Chinese people I’m always losing. I am too stingy to pay for items while they are spending very freely!

[9:42] Y: Don’t forget that two-thirds of Chinese gamers also watch esports. Tencent is well positioned there having invested in the recently IPO’ed Huya, a game streaming platform. Tencent has been pretty consistent about investing in esports, and estimates that by 2020, almost 60% of global esport users will be Chinese. I think we can credit Mark with a lot of this foresight.

[10:07] R: Now we don’t know if Mark is a gamer like Pony, and that’s why he’s so good at this stuff, but what we do know is that industry insiders attribute part of his success to being a master recruiter. He’s revered for his patience, engaging for years before going in for the kill. Seriously. He’s known for multi-hour interviews – apparently he conducted a ten-hour interview once – and also likes to test the candidate outside of the office to get greater insight into their character.

[10:38] Y: So, it’s no wonder then that when the first sign of trouble came about in the beginning of 2017 with the steep upward climb of Toutiao, Mark was asked to take over. Sure, in the press release, it was made to seem like Malaysian SY Lau 刘胜义, who had previously been President of OMG, was promoted to Chairman of Tencent Advertising, group marketing and global branding. But actually it was probably a demotion.

[11:05] R: Well, it wasn’t that he did a bad job. The last year under his rule, OMG had grown over 50% and accounted for 18% of Tencent’s revenues. But it was also true that in the announcement of his so-called promotion, the management specifically mentioned “greater algorithmic breakthroughs” as the next step for the company. Many took it to mean that Pony wasn’t happy with the lack of technological advances while SY Lau versus Toutiao’s aggressive data-driven approach.

[11:37] Y: However, as much as Mark’s star continues to shine bright in gaming though, I am not sure he’s really made a dent versus Toutiao. In fact, Quest Mobile’s latest monthly results show that Tencent’s share of total mobile usage time in China decreased from 54% to 48% from June 2017 to the same month in this year. And who accounted for basically all of that 6% loss? Bytedance’s family of apps, which include Toutiao, Douyin, and a few others.

[12:09] R: As we’ve already mentioned and covered in Episode 9, Tencent is obviously very, very worried. But recently, some analysts have voiced the concern that it is not just a technological issue but a company structure issue that keeps Tencent behind. Yes, that’s true, Bytedance has something like 800 data scientists whereas Tencent has far less. But the crucial difference seems to be that, whereas Bytedance has an open-door data-sharing policy across its multiple apps, Tencent’s apps are siloed by department and data aren’t shared freely, according to insiders. For example, Wechat’s ads are supposedly sold by the advertising group and not the Wechat group. Presumably, the two groups have different data on the users, as well as different objectives.

[12:56] Y: That’s just what we are reading. But it does sound believable based on Tencent’s widely covered 赛马机制, or horse-race protocol, where basically multiple internal teams are working on the same product, and the best one wins. Obviously, the teams are competitive with each other, not cooperative. It may sound redundant, but this is actually how Wechat was created.
R: It is precisely this kind of lack of deep data integration that is speculated as being behind the reason why Starbucks left Wechat for Alibaba ele.me. So Wechat actually cooperated with Starbucks first, the BD team did a ton of work and made the deal happen. But it stayed at the relatively superficial level of Wechat payments in Starbucks stores as well as a mini app. With the recent Alibaba and ele.me delivery deal, however, Starbucks is apparently willing to share one of its most important assets – its entire China membership database.

[13:53] Y: This is kind of ironic given that back in 2014 Tencent’s vision had been rebranded as 连接一切, or “to connect everything”. Remember, even back then Tencent had the vision of an open IoT platform where you could connect everything to Wechat. Of course, Wechat’s core functionality already connected people to each other, but it had grander dreams of connection people to everything else — whether it be information in the form of official accounts, or vendors, both online and offline, in the form of payments. These days, even more connections are made through miniapps, or applets, as they’re sometimes called. These 小程序 connect the users to other apps and services, often big platforms such as Didi or JD. But apparently, while Tencent connects the user to many of its own products and services, those products and services are not connected to each other.

[14:58] R: I think the insight here is that in an increasingly AI and algorithm driven world where data is king, Tencent’s way of creating product may no longer work as well as it has in the past. In the past innovations in design or functionality might have been more important. But in today’s world, Bytedance’s system, where data is not siloed and there is no internal competition, might reign supreme. Maybe a slight oversimplification, but I think it’s still a really important theme to think about going forward.
Y: That is indeed an issue, Rui, but I think it’s too subtle for most public market investors to react to in the short term. In the short term, Tencent has other problems, most notably its issues getting games approved to be distributed in China.

[15:44] R: Well, technically, in some cases, they’re actually already available to play but Tencent can only operate them in “public beta” mode, which means that it cannot monetize off of them. So that’s not really helpful. The first piece of news that the market reacted to was how Tencent had to pull game “Monster Hunter: World” from its WeGame platform after launching it earlier in August. This game is made by Capcom of Japan and has been a hit outside of China. Tencent had bought the rights and was hoping to distribute it on the mainland.

[16:18] Y: Two other games that may be even bigger hits are also delayed. One is “PlayerUnknown’s Battlegrounds”, commonly referred to as PUBG, and the other is Fortnite. For the creators of both games, Tencent has distribution rights as well as an equity stake. It owns 11.5% of PUBG creator Bluehole and 40% of Fortnite creator Epic Games, so it’s not like they’re not benefitting from the games’ popularity outside of China, but that’s obviously small stakes compared to what they could be earning if the games were greenlit for distribution.

[16:54] R: In a rare acknowledgement by Tencent management, President Martin Lau said that these instances were beyond the company’s control. China’s General Administration of Press and Publication, which is the regulatory body governing such decisions, is apparently in some kind of “shakeup,” as reported by Bloomberg. So everyone is affected, not just Tencent.
Y: People actually started covering this a few months back, folks like Ben Thompson of Stratechery back in April, but it really caught everyone’s attention this month when major media outlets such as Bloomberg made a big deal out of it.

[17:28] R: Because this particular move got so much attention, though we decided to ask a friend of ours who is also an expert. Lee, could you introduce yourself?
L: My name’s Lee Gao, and I help run the Emerging Markets Sustainable Growth Fund at GCA. For full disclosure, our fund does hold a position in Naspers, which owns a third of Tencent. But hey, that’s why I follow it.

[17:50] Y: As with any investor, Lee’s opinions are his own and do not represent those of his fund, GCA. Anyways, what’s interesting here is that Lee, you said, this has happened before?
L: Yeah, we’ve actually seen this 9 years ago. One of the few analysts out there who had also been covering the space back then and honestly there aren’t that many left now, his name is Han Joon Kim at Deutsche Bank, and he noted in a report that these exact same delays happened during another regulatory changeover back then and they took 6 months to resolve. So since the delays started around April or May this time, we should be done by September or October if everything goes according to schedule. Again, China is not banning all games. It’s just bureaucracy and bad luck.

[18:39] R: Yeah, and Tencent is especially unlucky because PUBG is Korean right?
L: As you may know, Beijing and Seoul had been having a bit of a tiff for over a year over the THAAD missile defense system that was being installed by the U.S. in South Korea. That’s been getting resolved since President Moon Jae-in got elected last year with a much more conciliatory stance towards both North Korea and China, but it’s not quite completely over yet. So you can chalk that particular delay up to bad luck as well. And there’s actually more bad luck, because Tencent had already launched PUBG before Chinese regulators started what they call a “green channel”, kind of like a soft approval process to temporarily let games monetize for a month to bypass what they acknowledge are pretty annoying delays. Because PUBG was already out before this green channel concept came out, Tencent can’t retroactively put it through the green channel and start monetizing it by charging for items in the game, even though it’s Tencent’s biggest mobile game now. It’s basically really really bad luck.

[19:45] Y: All right. Fair enough. Tencent might need to hire a new fengshui master. This does indeed seem out of their control. But what can Tencent do now?
L: In the meantime, Tencent can either just wait for the backlog to clear or they can be proactive. Obviously being Tencent, they’re being pretty proactive. One of the creative things they’re doing is giving away items in PUBG if you take up a Tencent Video membership, kind of like their Netflix or Amazon Prime Video. It’s not really monetizing PUBG directly, so steers clear of any regulatory issues, and it also helps other parts of their business. The fact that they can do this is one of the biggest reminders that Tencent is so much more than a game company. Games today are only around 40% of Tencent’s revenue and now that was probably going to fall even more and even without the regulatory delays as ads and payments and cloud keep growing. Incidentally, this cross promotion between Tencent Video and PUBG runs until late September, which happens to be around 6 months after the regulatory delays started. You gotta think – what a coincidence!

[20:56] R: Super, super insightful. Thanks for that, Lee. I know guys it seems like the Chinese government is so pro-tech and protective of its internet giants, but I think this serves as a good reminder that in China, you can never predict what the government does, and it doesn’t really matter even if you are as large as Tencent. The government will do what it does. But do I think I agree with Lee here, this seems to be a temporary blip.
Y: Yeah, the company’s stock price was already pretty low prior to the announcement and while it dropped on the news, it wasn’t by that much, about 3.7% or so. I do still think that there is a fundamental adjustment of how people are looking at Tencent’s overall strategy. In Episode 5 on our podcast Has Tencent lost its Mojo? Rui and I talked about how some feared that Tencent had stopped generating its own hits and was overly reliant on investments for growth.

[21:46] R: The original impetus of that, of course, was Tencent trying to escape its reputation as a copycat of other people’s products, but apparently, that’s now turned out to be too self limiting. The strategy used to be to go after everything, became “Tencent will stick to what it knows best, and support partners who are good at the rest.” Some analysts still think that this means Tencent has dropped the ball on several major opportunities. The most notable one is Weishi 微视, the short video product that might have been a strong competitor to Bytedance’s Douyin, but was effectively shut down and had to be revived with promises of over 400 million in promotional subsidies.

[22:27] Y: Honestly, I feel bad for Pony and Tencent. It’s a little bit of damned if you do, damned if you don’t. You clone and expand your business and people call you a thief, and you invest liberally and shut down controversial apps and people are like, you’ve become soft and useless and complacent.
R: And this is where I think investors are just fickle. I mean, they didn’t blink an eye when Martin Lau, said as recently as March that the reason Tencent did so well in 2017 was because of “investment we made years ago.” And was widely applauded for that. I guess no one really picks at you when you’re up for the year and outpacing the index, but as soon as you’re down, boy do they find every bone to pick with you, including the very investment strategy that got you to the top in the first place.

[23:18] Y: Anyway, some of you might be wondering why we didn’t talk about Wechat so much this episode. Well, the truth is that Wechat has continued to do well, and is the bright spot in Tencent, not the cause of its price drop. It’s also way too big and complicated to sneak into this episode, and absolutely deserves its own analysis. But it is true that Tencent will not be able to make money from funds held in Wechat Pay wallets anymore.

[23:45] R: Yeah, it used to be that companies could take customer deposits and invest them for a return. But now, in an effort control risk, and in what I think is the right decision, the Chinese government has required, beginning in April, that payment platforms like Ant Financial and Tencent keep a 50% reserve ratio, you know, they are not banks, and shouldn’t be playing around with user balances. Recently, the government further announced that reserves will go up to 100% by next January. That means there will be no more money to be made from customer balances in third party payment platforms. Honestly though, that doesn’t affect Tencent very much. It’s just not a big part of Tencent’s revenues right now. Alright, Yingying, shall we wrap it up?

[24:32] Y: Yeah. I think we’ve gone over most of it. I’d just like to leave our listeners with one more little story though.
R: What’s that?
Y: You know, during the course of researching this story I learned that Pony doesn’t play Honour of Kings, Tencent’s hit multiplayer online battle arena game of 2017, but apparently he is a big fan of the battle royale game PUBG, which we talked about in detail earlier. In Chinese though, it’s called 吃鸡游戏, which literally means “eating chicken game.” Apparently, that comes from the line in the game when you win: 大吉大利,晚上吃鸡, which actually comes from the English “winner winner, chicken dinner.”

[25:15] R: That is so, so, so weird.
Y: Yeah, tell me about it. Anyways, my point here was that it seems like Pony, who’s generally considered Mr. Nice Guy, Mr. Softspoken Nerdy Guy, is a lot more competitive than we think.
R: Interesting. Whereas Lei Jun likes to play the much more team-oriented World of Warcraft. PUBG, on the other hand, that game requires you to kill everyone else and be the last remaining survivor, at all costs! Kinda explains the internal competitiveness too within Tencent. Maybe it’s just one big Battle Royale game to Pony and team.
Y: Well. Can the Tencent team do it? Will they get the chicken dinner, I mean, the $140 billion back? What do you guys think? Let us know your thoughts by tweeting at us at @techbuzzchina!

TechBuzz China by Pandaily is powered by the Sinica Podcast Network. Pandaily.com is a new English language site that tells you “everything about China’s innovation.” You can find us on twitter at @techbuzzchina and @thepandaily, or reach out to Rui and Ying-Ying at @ruima and @ginyginy. Our producers are Carol Yin and Kaiser Kuo. Our interns are Ska Du and Wang Menglu.