Fresh regulatory requirements for Tencent

Regulatory concerns mount as China launches a series of crackdown on misconduct in the internet industry. First there was Alibaba (BABA). Then, DiDi Global (DIDI). Now, China is cracking the whip again, and this time, it’s Tencent.

Here’s what happened. On August 3, state-affiliated media in China said that playing online games is addictive and went so far as to call online games ‘spiritual opium’. In the article, the Economic Information Daily was wary of impacts from pop culture, saying "no industry, no sport, can be allowed to develop in a way that will destroy a generation.” Tencent’s blockbuster game Honour of Kings was singled out as an example for causing a detrimental impact to the country’s youth.

Although the state-run media quickly took down the op-ed, the market picked up on it. Shares of Chinese online gaming companies were down substantially on fears that the episode with the after-school tutoring sector will replay with game developers. Tencent’s share price shredded 4.8 per cent. NetEase and CMGE Technology were down 6.9 per cent and 14.1 per cent, respectively.

A market overreaction

Ivan Su, senior equity analyst at Morningstar, believes the market reaction on Tencent was overblown for several reasons.

First, the restrictions on playing hours is not new – it has existed for a few years now.

After the official media critique this week, Tencent says it will further restrict minors’ playing hours to 1 hour from Monday to Friday, and 2 hours for holidays. In fact, a milder version of such restriction has been in place for some time now. In May 2020, the government brought in rules that limit the time that underage gamers spend on Tencent’s Honours of Kings. Those under 18 years can play the game for a maximum of 1.5 hours on weekdays and 3 hours on the weekend. In fact, from as early as 2019, teens have been banned from playing between 10PM and 8AM as the government says gaming at night would impair eyesight.

Su says the minimal impacts caused by these rules were reflected on Tencent’s profitability through the last quarter.

Second, Su says that investors should not overlook the typical business model of game development studios.

“Their revenue stream is mostly derived from adult gamers -- in the forms of in-game subscriptions or top-ups. The way for Tencent and peers to monetize a mobile game isn’t likely to change on this news.”

Furthermore, at this stage, no tangible policy changes have been proposed. Su’s fair value estimates of Tencent, NetEase, and CMGE remain unchanged. He estimates that spending by minors represents about 6 per cent of Tencent's gross revenues from the segment, a low single-digit percentage of NetEase's, and an even lower percentage for CMGE. He says, “Even if the government was to impose a blanket ban on underage gaming, assuming an impact on developers across the board, downsides in valuations are capped at about 5 per cent, in our view.”

Back to fundamentals

This round of correction has made Tencent’s shares more compelling. The wide-moat company ended August 4 at HK$446 and has an appealing 80% upside potential to Su’s fair value estimate of HK$800. Tencent has multiple moat sources, which are some significant advantages that can help it withstand competition over the long term.

According to Su, Tencent’s sprawling network through its all-in-one messenger WeChat has collected a massive user base. Its flagship platform, which comprises payment, a social network and games, has a total of 1.2 billion users. Sticky users and systematic monetization of various verticals are likely to preserve Tencent's economic moat for the next two decades.

Also, the company harnesses intangible assets, such as a vast collection of user behavior data and content/IP ownership to develop games and a social media strategy.

Other than economic moat, Tencent is given an Exemplary Capital Allocation rating, which implies it has been good at channeling resources into profitable projects. In the case of Tencent, the company management is committed to investing in enterprise digital services to tap into demand for cloud services and enterprise software, particularly to meet remote office needs after the outbreak of the coronavirus.