Tencent's Video Game Business Is Out, but It Has Other Horses in the Race

The bad news for China's video game industry keeps getting worse. Regulators started blocking applications for new game releases earlier in 2018, citing the negative effects that excessive play was having on kids -- things like nearsightedness, increased risk of obesity, and the popularity of violent titles.

Chinese video game titan Tencent Holdings (TCEHY 5.23%) revealed over the summer that it had a workaround. Known as the "green channel," the process allowed video game publishers that had already received approval for a new title to release and monetize it. That last avenue for getting new games to the public has now been closed, though.

New video game releases likely won't be permitted until a Chinese regulatory overhaul and reorganization is finalized in early 2019, which doesn't bode well for Tencent's video game segment. That, paired with ongoing worry over a trade dispute with the U.S., has sent Tencent shares down as much as 44% from their all-time high. The news coming out of China doesn't sit well with shareholders, and it in no uncertain terms means that Tencent is in trouble.

Image source: Getty Images.

Lots of irons in the fire

Not much should be expected from the video game segment for a while -- at least not in China. Tencent is upping its distribution internationally to compensate, but in the meantime there are plenty of other businesses under the Tencent umbrella that can move the needle.

Data source: Tencent. Chart by author. RMB = Chinese renminbi. YOY = year over year. 

Tencent generated total revenue of 147 billion Chinese renminbi ($22.2 billion) in the first half of 2018, a 39% increase over the first half of 2017. Value-added services (VAS), which contains the video game segment, also includes social media services, video streaming, live broadcasts, and music streaming. All of those areas are growing by double digits, and as of midyear, Tencent had 154 million paying subscribers (across all of its services combined).

Then there's online advertising, most of which comes from Tencent's social networks WeChat and QQ. WeChat, and to a lesser extent QQ, are mobile messaging apps that are also all-in-one platforms that host other services like mobile payments, ridesharing, and entertainment. Think of each one as a single app that can handle most needs of the average Chinese smartphone user. WeChat had 1.06 billion monthly active users at the end of June 2018, and QQ had 803 million. That's a lot of users for advertisers to have access to, and Tencent is only getting started in figuring out how to maximize the value of this business.

The "other" segment, the fastest-growing and -- up until a couple of quarters ago -- smallest of Tencent's three reportable segments, includes digital payment and cloud-computing services. Payment and financial services exceeded 800 million users at the end of June, and average daily transaction volume has increased 40% from a year ago. Cloud service revenue has been doubling year over year as Tencent grows its capabilities in data analysis and artificial intelligence. Tencent has been growing its cloud-computing presence outside of China, too.

Bet on games coming back

While video games' hitting a roadblock in China may be concerning, much of that worry has been priced in by the declines this year in Tencent's stock. Nevertheless, the business as a whole continues to grow at a rapid pace, justifying its relatively rich valuation of 27.4 times trailing earnings.

Pundits say that a decline in Tencent's profit margin this year is a concern, but most of that is due to the gaming slowdown combined with Tencent's aggressive investment in its high-growth initiatives. Plus, the halt in new video game approvals in China won't last forever. When they come back, look for this beaten-down Chinese tech stock to rebound in a big way.