Will Tencent Rally as China’s Video Game Winter Ends?

Chinese regulators abruptly suspended all approvals of new video games in early 2018, which caused the growth of the world's biggest gaming market to hit a brick wall. The ban was mostly sparked by concerns about gaming addiction, violence in video games, myopia rates among children, and a perceived need for tighter approval standards.

The ban hit Tencent (TCEHY -0.44%) particularly hard, since the Chinese tech giant generated about a third of its revenues from online games. Tencent was forced to suspend Capcom's (CCOEF -0.25%) hit PC game Monster Hunter: World shortly after its Chinese release, while approvals for the monetization of PUBG Mobile and the PC versions of PUBG and Fortnite were left in limbo.

Epic Games' "Fortnite". Image source: Epic Games.

Tencent subsequently squeezed out some new licensed games which were approved prior to the freeze, but its core growth engine was still running on fumes. Tencent subsequently restructured its business to divert funding for new games toward its higher-growth cloud, digital media content, and payment services.

Many analysts expected the "video game winter" to last until the first half of 2019. However, Chinese regulators recently restarted the gaming approval process ahead of schedule, and investors in Tencent and other gaming companies breathed a collective sigh of relief. But will new approvals finally help Tencent's stock -- which shed over 20% of its value in 2018 -- finally recover?

Understanding Tencent's gaming business

Tencent is the largest video game publisher in the world by annual revenue. Its most well-known titles include League of Legends, Honor of Kings (also known as Arena of Valor), and Clash of Clans. Its stakes in Bluehole and Epic Games also grant it the Chinese publishing rights to the battle royale hits PUBG and Fortnite, respectively. The impact of the suspended gaming approvals clearly left a mark on its online gaming business over the past five quarters:

Tencent's online gaming revenues. Source: Quarterly reports.

Tencent's decline in online gaming revenues last quarter wasn't as bad as feared, as it managed to squeeze out ten pre-approved mobile games, including Free Fantasy Online Mobile, MT4 and Saint Seiya, which complemented the strength of its top title, Honor of Kings. As a result, its mobile gaming revenues actually rose 7% annually.

However, that growth was offset by a 15% drop in its PC gaming revenues, which was caused by casual gamers pivoting toward mobile devices. Tencent planned to stem the decline earlier this year with the launch of Monster Hunter: World on its Steam-like WeGame platform, but it's unclear if Tencent will get a green light to relaunch the game.

Capcom's "Monster Hunter: World". Image source: Capcom.

Missed opportunities and upcoming catalysts

Restarting game approvals could enable Tencent to post double-digit annual sales growth in gaming revenue again. However, the Chinese approvals for the PC versions for PUBG and Fortnite (and the microtransactions in PUBG Mobile) might occur after gamer interest in battle royale titles -- which were red-hot throughout 2018 -- cools off.

On the other hand, Fortnite remains one of the most popular core PC titles on the market according to Newzoo. China's gaming market is also large enough to be self-sufficient without connecting to players in other countries, so it might simply experience a delayed growth spurt in battle royale games, which would be amplified by its booming esports market.

Winning an approval for Monster Hunter: World would also be big, since Chinese gamers have been waiting for the PC version for nearly a year. If Tencent gains approvals for PUBG, Fortnite, and Monster Hunter: World, then simultaneously launches them on WeGame, we could see a sudden surge in PC gaming revenue throughout 2019. However, China's gaming approval process remains opaque, and it's unclear if Tencent needs to significantly censor or alter those games to win over regulators.

Keep focusing on the non-gaming businesses

The end of Beijing's gaming approval ban is good news for Tencent, but investors should remember that the company pulled itself out of a nosedive last quarter by wisely focusing on the growth of its social networking, advertising, digital media, cloud, and payment revenues.

YOY growth in RMB terms. Source: Tencent quarterly reports.

This means that even with its gaming business stuck in the mud Tencent was able to generate double-digit revenue and earnings growth. Now that its gaming business is finally allowed to grow again, its growth should accelerate again and help the stock recover throughout 2019.