NETTF - Tencent: Don't Panic On The New Gaming Rules

2023-12-22 06:59:30 ET

Summary

• Tencent and other Chinese gaming companies’ market caps are heavily hit by new regulatory proposals.
• While the exact effect on Tencent’s revenues is unclear and regulations are not final yet, the stock market is rightly worried about repeated, unpredictable regulatory interventions.
• Fortunately for Tencent, it has diversified away from Chinese gaming over the past five years.

What are the new regulatory proposals for the Chinese gaming industry?

Reuters has a short summary of the new regulatory proposals that hit the shares of gaming companies in China so heavily overnight: Tencent (TCEHY) (TCTZF) was down up to 15%, while NetEase (NTES) (NETTF) lost even 25%.

The new rules will effectively set spending limits for online games. Online games will now be banned from giving players rewards if they log in every day, if they spend on the game for the first time or if they spend several times on the game consecutively. All are common incentive mechanisms in online games. ... Besides banning reward features, games are also required to set limits on how much players can top up their digital wallets for in-game spending. Games are also banned from offering probability-based lucky draw features to minors, and from enabling the speculation and auction of virtual gaming items.

While in recent years regulators have mainly focused on the protection of minors, the new proposals apparently take aim at the financial effects of gaming addiction.

The proposals surface in a time of economic uncertainty in China, with rising youth unemployment and sluggish consumer spending, and are presumably trying to protect citizens from developing financially destructive behavior during periods of unemployment.

The new regulations are not final yet, as the administration is seeking public comment on its proposals through Jan. 22, 2024.

Also included in the proposals is a requirement which the gaming industry will certainly love: In the future, regulators might be required to process game approvals within 60 days. In recent years, approvals have frequently been halted for several months and caused significant planning uncertainties.

Why did the stock market panic on news of stricter gaming rules in China?

First of all, the new proposals came as a total surprise. Financial markets were just starting to believe that the "tech crackdown" was over, when tech businesses were hit again. Coupled with the perception that Chinese regulators can request basically anything without appeal, these attacks out of the blue are something that investors probably hate most, as they create a permanent climate of uncertainty. What is immediately impacted by this unpredictability is the trading multiple of Chinese tech: Nobody wants to pay a high multiple for earnings that can be permanently curbed by the strike of a bureaucrat's pen.

Second, there will be a financial impact. We don't know, how many of Tencent's adult gamers are pathological addicts and would be (rightfully) protected by the new rules. It is also hard to estimate how overall monetization could be impacted, if spending limits are introduced, rewards for first in-game purchases or frequent log-ins are eliminated.

If the impact was sizable, which is certainly possible, Tencent would probably need to completely rethink monetization and this means that games overall would need to change.

Is there anything positive in the new gaming rules?

I already mentioned the accelerated approval process. This should eliminate some uncertainty. Tencent could plan launches and support them more precisely, which should improve economic results.

Moreover, any complex set rules always benefits the one that can adapt to them - and this is usually the bigger company, whereas smaller, less diversified competitors can be killed if their only source of income heavily relies on mechanisms impacted by the new rules.

So there is this competition angle to consider: What if the new rules impact a strong competitor like NetEase a lot more than Tencent - and the latter gains share as a consequence? Effectively, NetEase depends a lot more on gaming revenues than Tencent. Or what if other competitors' emergence is slowed down by the new rules?

Is Tencent a buy on the gaming-regulation sell-off?

In Q1/16, Chinese online games represented close to 53% of Tencent's revenues or RMB 17B (there were some minor international revenues included, but we don't know exactly how much). The segment grew strongly until the first "gaming crackdown" in 2018, when quarterly gaming revenues were RMB 24B. However, the rest of Tencent had grown a lot more, as these RMB 24B represented only 28%. Fast forward five years, Chinese gaming is down to 21% of quarterly revenues (RMB 32B), while the growth is clearly in international gaming, which is up to 9% of total sales (RMB 14B).

In a nutshell: Chinese gaming used to be the most important part of Tencent's business, but today the new gaming rules will only impact 21% of its revenues. This means that a 15% sell-off is certainly a total overreaction, as it implies an almost total wipe-out of the Chinese gaming segment.

As I said, Tencent's growth is elsewhere. Given the company's enormous market share and size in the Chinese gaming market it would have been foolish anyway to bet on above-market growth. Fortunately, the company recognized its limits early and expanded into other sectors.

In Q3/2020, international games represented RMB 10B of revenues, in the last quarter these had grown to RMB 14B. In the meantime, Chinese games were roughly stable.

This is why I believe the market is wrong when it thinks Tencent as a "Chinese gaming business". The truth is that Chinese gaming is a shrinking part of its overall revenues and becoming less and less important quarter after quarter.

Overall, I believe the new regulatory intervention won't have a huge impact on the company. Even if it shaves 10% off its Chinese gaming revenues, the total impact would be minor: 2% of total sales. And there will likely be positive offsets, e.g. the greater planning certainty due to fixed approval timelines and some market share gains.

After the sell-off Tencent has a market cap of about $300B, a small net cash position and quoted and unquoted investments worth over $100B. Which means the entire cash-generating business is trading for just $200B or below 11x EPS (expected for 2024).

This is obviously cheap and clearly discounts the heavy burden of frequent, unpredictable regulatory interventions. That said, I believe that Tencent's business has become so diversified that it is far more resilient against these threats compared, e.g., to Alibaba (BABA) or its gaming competitor NetEase. Even after today's news, investors can count on strong growth in international gaming, advertising, fintech and business services and a stable base in social networks. Together these segments account for 79% of total revenues and will likely add far more RMB than the new gaming rules will take away from Chinese gaming sales.

For further details see: