When Video Games Come Back for Tencent, It Will Be Icing on the Cake

Video game giant Tencent Holdings (TCEHY 5.23%) has been posting robust revenue growth even as its primary business has hit roadblocks in China. That's because Tencent is much more than just a video game producer, a fact that many investors may be overlooking. With shares still down sharply to date in 2018, the eventual renewal of the company's most recognizable business may just be icing -- and that is fantastic news.  

Troubling times in China

Tencent and other Chinese-based video game producers have been grappling with a suspension on new game release applications this year. The Chinese government has taken a critical look at the industry as of late, citing game addiction among young players, health-related side effects from too much time spent in front of a TV or computer, and violent game content.

The freeze on new applications is also tied to a reorganization of China's regulatory authorities. That process isn't expected to be complete until sometime in 2019, which means relief for the video game industry may still be a ways off. Tencent's gaming segment has suffered, posting only 7% year-over-year growth in mobile (to 19.5 billion RMB), offset by a 15% year-over-year decline in PC games (to 12.4 billion RMB) during the third quarter of 2018.

Nevertheless, overall third-quarter revenue and earnings per share still increased 24% and 29%, respectively -- despite video games weighing down results and a drag on profit margins from Tencent's investments into new business segments (gross margin was 44% in the third quarter compared with 49% last year). However, Tencent has now demonstrated that its bet on itself is money well spent.

Image source: Getty Images.

Why Tencent is a rock star

While the video game business has deteriorated, Tencent's other businesses have caught up and now comprise the tech conglomerate's main revenue drivers. CEO Ma Huateng reported that "advertising, digital content, payment, and cloud services sustained robust activity and revenue growth, and now account for the majority of [Tencent's] revenue."

That's due in no small part to WeChat, Tencent's social networking platform. Monthly average users jumped 10.5% year over year to 1.08 billion users in the third quarter. The real value in WeChat lies in its user base. WeChat is increasingly becoming a one-stop shop for mobile, enabling everything from online ordering and payments, entertainment like streaming TV and music, live broadcasting, and advertising. Then there's cloud computing for enterprises, which is lumped into Tencent's "other" segment. Those other businesses continue to perform just fine, with or without video games making any meaningful contribution.

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

The key takeaway is that Tencent's investment in new businesses is paying off. Though profit margins are under pressure from nonexistent video game growth and expansion efforts, investors are getting a good deal here. When the company can start filing for new game applications again, it will merely be icing on the cake.