So far, 2018 isn't turning out to be a great year for Chinese stocks, and video game and social media giant Tencent Holdings (NASDAQOTH:TCEHY) has been no exception. Shares are down 30% from all-time highs reached at the beginning of the year. There are many reasons for investor pessimism -- from trade wars to Chinese government crackdowns to shrinking profit margins -- and all of those concerns are valid. However, I believe that down the line, investors will thank Tencent bears for creating a great buying opportunity.
Top-line growth is strong
While total revenue growth is cooling off, Tencent's upside is nevertheless impressive. Revenue in the second quarter of 2018 increased 30% year over year, to $11.14 billion. First- and second-quarter revenues combined for $22.25 billion, a 39% increase over the first half of 2017.
Tencent is the world's largest video game company, but its video game segment was the biggest drag on growth in the last quarter, growing only 6% year over year. The company's big story continues to be advertising, a revenue stream which Tencent is only beginning to tap into. Online advertising rose 39% in the second quarter, with social media advertising specifically up 55%. Besides advertising, social media is getting monetized in other ways; through digital content and video streaming subscriptions, for example.
Revenue in "other businesses," Tencent's smallest segment, which includes services like cloud computing and digital payments, hit $2.64 billion. That's a massive 81% increase over the second quarter of 2017, although it represents a slowdown from the 111% annualized growth rate recorded in the prior quarter. Still, for a massive enterprise doing more than 11 figures in revenue each quarter, such growth rates are nothing to sniff at.
Investing fits and tantrums
Investors' problem with Tencent this round, as it was during the first quarter, was with softer profit margins. The company is investing heavily into new businesses, especially the "other" segment that's posting the biggest growth rates. As a result, Tencent's overall profit margin is in decline. Operating profit margin fell to 30% in the second quarter, from 40% in 2017. The drop was even more pronounced against the prior quarter (first quarter of 2018), when the company achieved an operating margin of 42%.
Tencent warned this would be the case a few months ago, so at least some of this drop should have been anticipated by investors. The big culprit was a dramatic 74% jump in selling and marketing expenses to $961 million during the second quarter. Combined with a few other smaller expense line items, net profit margin fell to 25%, from 32% in the prior-year quarter, leading to Tencent's first drop in overall profitability in over a decade.
As any good investor knows, returns can be lumpy. While profits in Tencent's recent report may be smaller than what shareholders expected, the key takeaway is that revenue is still rising, signaling a potentially bigger payoff in the future.
Tencent has been here before
As mentioned above, Tencent's video game segment was a disappointment this quarter. Revenues were "only" up 6%. That's still an impressive feat considering the current regulatory environment in China.
Internet crackdowns present a constant challenge to businesses that mush work around them in China, and for video game developers, times are tough at present. Due to regulatory department restructuring, the Chinese government has placed an indefinite freeze on new game license approvals. That means some of Tencent's biggest licensed titles, like Fortnite and PlayerUnknown's Battlegrounds, can't be monetized in the world's most populous country until they get the green light from the powers that be.
The good news is that regulatory intervention is nothing new, and Tencent has dealt with this before. Company President Martin Lau said on the company's second-quarter earnings conference call that he believes "it's not a matter of whether these games will be approved for monetization; it's a matter of when exactly we can actually do that." In the meantime, the company has "at least 15" other games in its portfolio doing business as normal. Plus, the Chinese government is aware that its shake-up is having a detrimental effect on the game industry, so there's confidence things will normalize soon: No need for panic at the moment.
It's been a news-filled year for Tencent, and the bad news is currently winning. However, the fundamentals of the business are still sound, and this $400 billion mega-cap stock is still finding ways to grow fast. While the bears are having their way at the moment, the current situation has only created a buying opportunity for investors who can cut through the noise.