Tencent (NASDAQOTH:TCEHY) is considered one of the safest and most well-diversified plays on China's booming tech sector. It owns WeChat, the top mobile messaging app in China with over a billion monthly active users (MAUs); its gaming portfolio makes it the biggest video game publisher in the world; and it owns an expanding ecosystem of cloud and payment services.
However, Tencent's stock slumped about 25% this year due to some serious concerns about its long-term growth. Let's review the three biggest headwinds for the company, and whether or not they could derail its business.
1. The gaming crisis in China
Tencent's online gaming revenue accounted for 34% of its top line last quarter. This business was once Tencent's core growth engine, but its online gaming revenue fell 6% annually during the quarter as a 5% drop in its PC gaming revenue dented its 19% growth in smartphone gaming revenue.
Tencent initially thought that it could strengthen the business with the approvals of Fortnite and PUBG for PCs in China, along with the approval of microtransactions for PUBG Mobile. It also saw Monster Hunter World, a hit PC title which it licensed from Capcom, as another blockbuster title.
Unfortunately, Chinese regulators abruptly forced Tencent to suspend sales of Monster Hunter World in August for unclear reasons, then suspended all new gaming license approvals -- including Fortnite and PUBG -- amid concerns surrounding gaming addiction. That unexpected development threw a wrench into Tencent's video gaming business, and raised serious questions about the unit's ability to keep growing in China, the world's top video gaming market.
2. The growth of ByteDance
A recent report by QuestMobile revealed that Tencent's share of China's mobile communications app market (with apps like WeChat, QQ, and Qzone) fell to 47.7% in June, compared to 54.3% a year earlier. During the same period, ByteDance's market share grew from 3.9% to 10.1%, with most of its gains made at Tencent's expense.
ByteDance owns the news aggregator app Jinri Toutiao (which has over 200 million MAUs), the short video apps Douyin (also known as Tik Tok, which has over 500 million MAUs) and Xigua (which has over 100 million MAUs), and other popular apps. ByteDance is a major threat to Tencent because its apps are widely used by younger Generation Z users. Xigua also plans to challenge Tencent Video in the premium streaming video market with licensed and original content.
Tencent is trying to counter ByteDance by backing other high-growth platforms, including Jinri Toutiao's rival Qutoutiao and the Gen Z content platform Bilibili, but those underdog bets could be too scattered to counter ByteDance. If Tencent fails to contain ByteDance's growth, it could lose a generation of users who view WeChat as a "parent's app."
3. Competition in the cloud
Tencent recently restructured its seven main business units, retaining four of its original ones and introducing new dedicated units: the Platform & Content Group for its digital media and non-WeChat social platforms, and the Cloud & Smart Technologies Group for its cloud infrastructure platform, Tencent Cloud. That move was aimed at prioritizing the two new groups over its struggling video game unit.
Tencent has reasons to be optimistic about its cloud platform. It reported that its cloud revenue "doubled" annually last quarter, and cited it as one of the main reasons its "other" revenue rose 81% annually and accounted for 24% of its top line. The unit's other main growth engine was its payments (WeChat Pay) business, which is the second most popular payments platform in China after Ant Financial's AliPay, which is tethered to Alibaba's (NYSE:BABA) retail ecosystem.
However, the gross margins at Tencent's "others" businesses are significantly lower than the margins at its advertising and value-added services businesses. Tencent Cloud also remains an underdog in the crowded cloud market. Synergy Research recently ranked it the fifth largest cloud provider in Asia, trailing far behind Amazon Web Services (AWS), Alibaba Cloud, Microsoft's Azure, and Alphabet's Google Cloud, in that order.
Tencent wants to leverage connections to its WeChat and QQ ecosystems to attract enterprise customers, but it could face a tough uphill battle as it tries to gain market share against its bigger rivals.
Should you stick with Tencent?
I once called Tencent a stock to hold "forever" since its social media and gaming businesses seemed to have plenty of room to grow. I still stand by that claim, and I believe that it will eventually overcome its gaming issues and Gen Z challenges while growing its cloud business.
However, it could also be a long and painful process that will weigh down Tencent's growth for the foreseeable future. Therefore, investors should take a closer look at these headwinds and consider their investment time frame before buying this stock.
John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. Teresa Kersten is an employee of LinkedIn and is a member of The Motley Fool's board of directors. LinkedIn is owned by Microsoft. Leo Sun owns shares of AMZN and Tencent Holdings. The Motley Fool owns shares of and recommends GOOG, GOOGL, AMZN, and Tencent Holdings. The Motley Fool has a disclosure policy.