Game theory

A ‘Sweeping Black Storm’ has gripped China’s entertainment world in recent weeks. It might sound like another chapter of climate crisis but it’s actually the literal English translation of the country’s most-watched TV drama of the year: a corruption saga about a policeman fighting for his reputation after being framed by his superiors.

Tencent, the company behind the series, has struggled with some nasty squalls of its own this year. As a leading light in the internet sector, the company has been buffeted by a slew of probes and rule changes. Regulators have targeted monopolistic behaviour and demanded better protections for personal data. New investigations have blown in thick and fast, creating the impression that the mood has darkened decisively against the so-called “big-tech authoritarians” – as Tencent and its internet peers have sometimes been described locally.

“When will it stop?” The Economist asks of the campaign in its series World Ahead 2022. At least $1 trillion has been wiped off the sector’s market capitalisation, the magazine reckons.

Tencent’s shares have plunged themselves, dropping from HK$773 in February to the HK$490 level in mid-November. Analysts have struggled to keep pace with the implications of the policy changes for the group’s profitability. Back in the summer they still had a consensus price target around the mid-HK$700 mark. Right now, that has dropped to HK$515.17, according to S&P Global Market Intelligence data.

With Tencent’s shares track record of stellar performance over the years, some analysts seem reluctant to switch to a sell rating. Although target prices have been slashed, the majority still class Tencent’s shares as a ‘buy’. But are they right to assume that the worst is over? The third quarter results gave some pause for thought. Revenue was up 13% year-on-year to Rmb142.4 billion ($22 billion) and net profit rose 3% to Rmb39.5 billion. However, the period saw Tencent’s slowest quarterly sales growth since its 2004 IPO. And had the group accounted for its net profit using pre-IRFS-19 standards, it would have recorded a loss as well.

Tencent’s management says there’s no need to fret and that the company is adjusting to the changing market conditions. “We’re proactively embracing the new regulatory environment, which we believe should contribute to a more sustainable development path for the industry,” explained Pony Ma, the company’s founder.

Local analysts believe that while Tencent’s growth trajectory may slow, the group isn’t likely to fall foul of the government in the same way as Alibaba and Didi Chuxing. Tencent is widely regarded as less of a target for regulators than some of its rivals. “Tencent has been self-regulating”, explains Michael Meng, an analyst from Bank of China International, flagging how the company has responded to government concerns by delivering a protection scheme for under-18s that play its highly popular online video games.

The company says that it doesn’t believe the same scheme – which severely limits gaming time – will be extended to adults but it must also respond to changes brought about by the implementation of the new Personal Information Protection Law (PIPL), which came into effect this month. Tencent says it is already complying with the new legislation (which allows people to correct or delete information held about them and withdraw their consent for their data to be handled by a company). But to make sure, the Shanghai Consumer Council has asked it to confirm whether it has stopped collecting data in cases where users have opted out of personalised ads or whether it’s still collecting the information but not using it.

In some ways Tencent should be well placed to deal with the tightening regulatory grip because it has experience of similar campaigns in the past. One example comes from 2018, when the government first became concerned about the risks of addiction to online video gaming, imposing a licencing freeze on new games titles, a costly pause for Tencent that lasted nine months.

Since then Tencent’s gaming revenues have more than doubled to Rmb53.43 billion, serving as the group’s single biggest revenue contributor at 37.5% of third quarter sales. International gaming sales are also a bright spot, up a fifth year-on-year. Tencent continues to grow its global reach. In 2020, subsidiary TiMi Studio set up its first gaming development studio in Los Angeles. This year it expanded into Seattle and Montreal as well.

As we wrote in WiC557, Tencent is also one of the tech giants leading the charge into the metaverse (shared virtual worlds that could reshape how we interact with our physical and digital surroundings).

Pioneers in the sector talk about the melding of virtual reality and augmented reality, social media and internet gaming into one. Tencent’s pedigree in video gaming and social networking should give it an edge. For instance, it already has a 40% stake in Epic Games, the US publisher of the hyper-realistic alternative universe Fortnite, as well as a strategic partnership with California-based Roblox, a game development platform that allows players to create their own identities in the form of avatars. In a further push into the sector, Tencent has also been repositioning one of its biggest titles Honor of Kings, with a new trademarking as ‘Kings Metaverse’.

Martin Lau, Tencent’s president, made a similar point on the company’s earnings call earlier this month after describing the metaverse as “very exciting, but a little bit vague”.

“We have a lot of tech and capability building blocks that will allow us to approach the metaverse opportunity through [multiple pathways],” he added, suggesting that there would be space to pursue profits because the Chinese government doesn’t seem “fundamentally averse” to the concept.

The world’s biggest tech groups won’t just be inviting their customers to open the door into these parallel worlds. They will also be asking some of their corporate rivals to join them too. Another of the government’s objectives in the regulatory shake-up is to crack open the tech sector’s closed ecosystems, where the internet giants have worked hard to close off their platforms to rivals’ users.

Times are changing, however. In another sign of the new era, Tencent has switched from suing Douyin (owned by Bytedance) for copyright infringement to this week allowing its users to post short-form videos featuring material from its films and TV shows on the rival platform – a huge concession and the removal of a major brick from its traditionally ‘walled garden’ approach.

Another of Tencent’s strategic initiatives is positioning itself as more of a partner to companies wanting to digitalise their businesses on the Cloud – a division that is now Tencent’s fastest-growing business.

A few years ago, analysts predicted that revenues from Tencent’s fintech and business services unit might account for half of sales by 2022. At 31.4%, the latest results show that there’s still some way to go to hit this target. But momentum is strong, with revenues rising 30% year-on-year to Rmb43.3 billion during the third quarter.

HSBC says this is a reason why Tencent is its preferred pick in the Chinese tech sector, notwithstanding the recent cut in its target price for the company from HK$655 to HK$590.

At its Digital Ecosystem Summit in Wuhan earlier this month, Tencent announced that it now has 9,000 business service partners across more than 30 industries. It has also developed more than 400 customer offerings, including software-as-a-service (SaaS) and platforms-as-a-service (PaaS) products such as Tencent Docs and Tencent QiDian (a customer relationship management platform). WeCity is the branding behind another of its major shifts into municipal services, which piggybacks on the multiple WeChat accounts and mini-apps set up by provincial and city governments. Local residents in many of these cities can now use Tencent’s payments tools to pay their electricity bills, for example.

The company has also started developing its own semiconductor chips to support future software development. It recently unveiled three new designs: Zixiao (the ‘place where immortals live’) for image processing; Canghai (‘wide open sea’) for video transcoding; and Xuanling (‘a god’) for storage and networking visualisation.

But will this be enough to bolster Tencent’s stock market valuation in the new era ahead? At 25 times forward earnings, the shares are currently trading below their long-term average of 28 times and at a significant discount to Western tech giants such as Microsoft (37 times) and Amazon (65 times).

Tencent still enjoys a premium over domestic peers like Alibaba (18 times) and Baidu (17 times). Investors will probably have to get accustomed to slower growth, although the more immediate difficulty is predicting how changes in government policy might hurt profits. Is Tencent now mostly in the clear on regulatory change, for instance? Or will the government soon turn its attention to new targets in the internet sector like third-party payments and short-form video, to which Tencent is also heavily exposed?

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