Tencent (NASDAQOTH:TCEHY), the largest video game publisher in the world, recently announced a strategic alliance with Japanese game maker Square Enix (NASDAQOTH:SQNXF). The two companies will form a joint venture company that will produce new games based on both existing franchises and new IPs.

Tencent could leverage Square Enix's well-known franchises -- which include Tomb Raider, Final Fantasy, and Dragon Quest -- to expand its overseas presence and reduce its dependence on the Chinese market. Square Enix, which offers a wide range of mobile games based on its triple-A franchises, could also leverage Tencent's WeChat, the top mobile messaging app in China, to reach more mobile users.

Square Enix's Final Fantasy XV.

Final Fantasy XV. Image source: Square Enix.

Why Tencent needs Square Enix

Tencent's online gaming revenue rose 6%  versus the prior year to 25.2 billion RMB ($3.69 billion) last quarter, and accounted for over a third of the company's top line. That growth was mostly supported by older games like the MOBA (multiplayer online battle arena) Honor of Kings (also known as Arena of Valor) and the racing game QQ Speed.

However, this growth rate represents a significant slowdown from the unit's double-digit sales growth in previous quarters. The unit's revenue fell 12% versus the prior quarter due to a 19% drop in smartphone gaming revenues and an 8% decline in PC gaming revenues.

Those numbers were disappointing considering how many top games Tencent owns. Honor of Kings is consistently the highest grossing mobile game in China, and the company also owns Riot Games, the maker of League of Legends, one of the top MOBA titles for PCs.

Tencent holds a majority stake in Supercell, the publisher of Clash of Clans, a 40% stake in Epic Games, the maker of Fortnite, and minority stakes in PUBG maker Bluehole, as well as Activision Blizzard, Ubisoft, and Glu Mobile. In addition, the company also recently partnered with Nintendo to launch Arena of Valor for the Switch.

Epic Games' Fortnite.

Fortnite. Image source: Epic Games.

Many Tencent investors expected three product launches in China to strengthen its gaming business: PUBG, Fortnite, and Monster Hunter: World, which it's licensing from Japanese publisher Capcom.

Tencent launched two mobile versions of PUBG in China, but microtransactions in the free-to-play games still haven't been approved due to gambling and addiction concerns. The PC versions of PUBG and Fortnite still haven't been approved, and regulators forced Tencent to pull Monster Hunter: World less than a week after its launch. To make matters worse, regulators temporarily suspended all new gaming license approvals due to an inter-agency shake-up.

With the Chinese gaming market stuck in the mud, Tencent needs to gain more international allies to offset the weakness of its domestic market -- and Square Enix seems to fit the bill.

Why Square Enix needs Tencent

Tencent senior VP Steven Ma declared that the alliance would link its "broad range of internet service capabilities" to Square Enix's "superb creativity" to produce "unprecedented content experiences" through a new joint venture company.

As a result of this partnership, Tencent might produce new games featuring Square Enix's stable of well-known video game characters for both the Chinese and overseas markets. In addition, most of Square Enix's core franchises, with the exception of Tomb Raider, aren't as violent as PUBG and Fortnite, which are both being scrutinized by regulators for their "battle royale" game mechanics.

Tencent could bring Square Enix's top mobile games -- which include ports of its classic Final Fantasy and Dragon Quest games, spin-offs like Final Fantasy: Brave Exvius, and new IPs like Chaos Rings -- onto WeChat, which is evolving from a messaging app into an all-in-one platform for online gaming, payments, deliveries, and other services. Square Enix could also launch more PC titles for Tencent's WeGame platform, which was hurt by the abrupt ban of Monster Hunter: World.

Square Enix's Dragon Quest XI.

Dragon Quest XI. Image source: Square Enix.

WeChat has over a billion monthly active users, and gaining top billing on the platform could prop up Square Enix's digital entertainment revenues, which tumbled 27% annually last quarter but still accounted for over 70% of its top line. The decline was mostly attributed to the lack of major console game launches during the quarter.

Not a magic bullet

Tencent and Square Enix could help each other out, but the joint venture won't solve either company's core problems. Tencent still needs to offer investors more clarity about the future of its gaming business in China, while Square Enix needs to expand its gaming portfolio beyond its core franchises to generate more consistent sales growth.

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