Shares of Tencent (NASDAQOTH:TCEHY) recently plunged after the Chinese tech giant posted disappointing second quarter 2018 numbers. Its revenue rose 30% against the prior-year comparable quarter, to 73.7 billion RMB ($10.7 billion), but that marked the company's slowest growth rate in three years, and Tencent missed analysts' consensus expectations for 37% top-line growth.

Tencent's net income slipped 2% to 17.9 billion RMB ($2.6 billion), marking the company's first year-over-year earnings decline since 2005 and disappointing expectations for 8% growth. However, non-GAAP net income -- which excludes impacts from acquisitions, investments, and other one-time expenses -- rose 20% to 19.7 billion RMB ($2.9 billion).

A gamer plays a video game on a laptop.

Image source: Getty Images.

Tencent's big miss was mostly caused by a significant slowdown in its online gaming business, which generated over a third of its revenue during the quarter. Let's take a closer look at why Tencent's biggest business is becoming a major liability.

A regulatory nightmare begins

Chinese regulators have generally been wary of video games. The government banned video game console sales in 2000 due to fears that games would impact the mental development of children, and only lifted the ban in 2015.

Last year, China's state-run People's Daily called Tencent's blockbuster mobile game Honor of Kings (also known as Arena of Valor) "poison" which fueled gaming addiction among minors. Tencent responded by limiting the daily play time for gamers under 12, and the media attacks ceased.

However, the Chinese government continued to scrutinize video games for a wide range of reasons, including their "distortion" of Chinese history in giving historical characters superpowers, their failure to promote "socialist" values, and their depictions of violence and adult content.

Fortnite: Battle Royale.

Fortnite: Battle Royale. Image source: Epic Games.

As a result, two of Tencent's biggest licensed PC games -- PUBG and Fortnite -- remain unapproved in China, likely due to their depictions of violence. Tencent's mobile versions of PUBG have received approval, but regulators haven't yet greenlighted the game's microtransactions due to concerns about gambling and gaming addiction.

However, Tencent suffered its biggest setback in mid-August when regulators abruptly banned Monster Hunter: World, a popular PC game it licensed from Capcom (NASDAQOTH:CCOEF), less than a week after its launch, for unclear reasons. This was a huge setback for Tencent's WeGame platform for PC games.

To make matters worse, Chinese regulators recently halted the approval of all new game licenses in China amid an inter-agency shakeup. It's unclear when the approvals will resume.

Assessing the damage

Tencent's online gaming revenues fell 6% during the quarter, a significant slowdown from the unit's double-digit sales growth in previous quarters. Here's how its smartphone and PC gaming businesses fared:

 

Revenues (RMB)

QOQ growth

YOY growth

Smartphone

17.6 billion

(19%)

19%

PC

12.9 billion

(8%)

(5%)

Source: Tencent Q2 report. QOQ=Quarter over quarter (sequential); YOY=Year over year.

Tencent's Honor of Kings and QQ Speed propped up its smartphone business, but the aging games couldn't offset a lack of new hit games during the quarter. The company's total daily active gamers grew year-over-year, but its monetization per user declined. Tencent likely expected PUBG Mobile to pick up the slack, but the hit game remains unmonetized.

Tencent's PC gaming unit continued to struggle as more gamers shifted toward mobile devices, while its top esports title League of Legends continues to lose players. The company expected Monster Hunter: World and the PC versions of PUBG and Fortnite to revive this business, but all three games remain locked out of China, the world's top gaming market.

But there's still hope...

Things look bleak for Tencent now, but the PC versions of Fortnite and PUBG could eventually be approved, along with microtransactions for PUBG Mobile.

For now, Tencent still has plenty of other high-growth businesses. Its value-added services revenue from social networks, which accounted for nearly a quarter of its top line, rose 30% in the second quarter, fueled by growth in paid subscribers across its media platforms like Tencent Video and Tencent Music.

Tencent's online advertising revenues, which accounted for almost a fifth of its sales, jumped 39% against the prior-year quarter, buoyed by the growth of its WeChat mobile messaging app (which expanded its monthly active users by 10% to 1.06 billion), its Moments photo-sharing app, its mobile advertising network, the news feed feature QQ KanDian, and more ads on Tencent Video.

Lastly, revenue from Tencent's "other" businesses jumped 81% in the second quarter and accounted for nearly a quarter of its top line. That growth was mainly attributed to the expansion of WeChat Pay and Tencent's cloud services. However, Tencent still lags behind Alibaba (NYSE:BABA) in both markets: Alibaba affiliate Ant Financial's Alipay is China's top mobile payments platform, and Alibaba Cloud is its biggest cloud infrastructure platform.

The road ahead

Investors will likely remain focused on Tencent's video game business or its costly ecosystem battles against Alibaba and Baidu, but the company still has plenty of irons in the fire. Its sales and earnings growth will likely remain lumpy for the next few quarters, but I believe that Tencent -- along with Alibaba and Baidu -- remain essential long-term plays on China's booming tech sector.

 

Leo Sun owns shares of Baidu and Tencent Holdings. The Motley Fool owns shares of and recommends Baidu and Tencent Holdings. The Motley Fool has a disclosure policy.