Tencent (OTC:TCEH.Y) recently posted its first-quarter earnings, and the results were a mixed bag. Its revenue rose 16% annually to 85.5 billion RMB ($12.7 billion), which missed expectations and marked its slowest growth rate since its IPO.
However, Tencent's net profit rose 17% to 27.2 billion RMB ($4 billion), beating estimates by 7.8 billion RMB. On a non-GAAP basis, which excludes acquisitions, investments, and other one-time gains, its net profit rose 14% to 20.9 billion RMB ($3.1 billion).
Tencent's growth is decelerating, but its first-quarter numbers indicate that its core business is stabilizing. I own shares of Tencent, and I don't plan on selling my position anytime soon for three key reasons -- the recovery of its gaming business, the growth of its new fintech and business services segment, and its disciplined focus on profit growth.
Tailwinds for the gaming business
Tencent's online gaming business, which generated a third of its first-quarter revenues, struggled with a nine-month freeze on new gaming approvals in China last year.
Regulators also refused to approve microtransactions for two of its licensed battle royale games, PUBG Mobile and Fortnite. Meanwhile, its aging flagship game Honor of Kings (also known as Arena of Valor) lost momentum with a 12% drop in monthly active gamers in March, according to Bernstein analyst David Dai.
The growth of PUBG Mobile overseas, fresh content for Honor of Kings, and the release of a new game, Perfect World Mobile, were the business's core growth engines during the first quarter. Unfortunately, a lack of new games still throttled the growth of its mobile and PC gaming businesses, and its total online gaming revenue fell 1% -- marking its third straight quarter of negative growth.
However, Tencent's gaming revenue rose 18% quarter over quarter -- with 11% growth in mobile gaming and 24% growth in PC gaming -- indicating that the business was finally recovering.
Two major tailwinds could help it keep growing -- the growth of Perfect World Mobile, which launched near the end of the first quarter, and Game for Peace, a new battle royale title that generated $14 million in in-app revenues within the first 72 hours, according to Sensor Tower.
Tencent discontinued PUBG Mobile in China after it failed to gain approval for its microtransactions, and allowed gamers to transfer their profiles and achievements to Game for Peace, a similar game that was approved for monetization and developed with the guidance of China's military recruitment unit.
Tencent also plans to release "several" new games in the second quarter and experiment with season passes for its top games -- which could lock in gamers and generate more stable revenues than in-app purchases.
A brand-new growth engine
Last October, Tencent restructured its business units to prioritize the growth of its cloud, AI, and fintech segments, and gradually reduce its dependence on its core gaming business.
Tencent disclosed the growth of those businesses separately for the first time in its new fintech and business services segment, which includes WeChat Pay, its wealth management services, and Tencent Cloud -- which IDC now ranks as the second-largest cloud platform in China after Alibaba (NYSE:BABA) Cloud.
Revenue from that new business segment surged 44% annually and accounted for a quarter of Tencent's sales. Tencent stated that its cloud business "sustained a rapid year-on-year revenue growth rate" as its paying customer base expanded and that monthly active merchants accepting its WeChat/Weixin Pay services "more than doubled" annually.
Expanding margins and impressive earnings growth
It's tough for Tencent to juggle cost-cutting measures (like its decision to layoff 10% of its managers), its investments in other companies, and the expansion of its ecosystem.
Yet Tencent's operating margin, which expanded 1 percentage point annually to 43%, indicates that it's pulling it off. As a result, its operating profit rose 20%. This indicates that Tencent is more disciplined than Alibaba -- which saw its operating margin decline year over year from 15% to 9% (partly due to a class-action lawsuit) last quarter.
Tencent's revenue growth should remain sluggish over the next few quarters, due to the gradual recovery of its gaming business and the softness of its advertising business (which grew 25% annually during the quarter but still decelerated significantly), but it should eventually accelerate again as its fintech and business services unit takes over as its core growth engine.
Meanwhile, its earnings should continue rising as it expands its margins, and the expansion of its ecosystem in multiple directions -- with WeChat's Mini Programs, WeChat Pay, Tencent Video, and its investments in adjacent markets via companies like JD.com and Bilibili -- should widen its moat.
Tencent's stock will likely remain under pressure, due to concerns about the trade war and the slower growth of the Chinese economy, but it remains one of the smartest long-term plays in China's massive tech sector.