Tencent (TCEHY 4.27%) recently posted strong first-quarter earnings that easily beat analysts' expectations. The Chinese tech giant's revenue rose 25% year-over-year to 135.3 billion yuan ($20.6 billion), while its adjusted net income increased 22% to 33.1 billion yuan ($5.0 billion).
Tencent's stock only rose slightly after the report, and it remains more than 20% below its 52-week high. Let's review the five main reasons investors shrugged after the company's latest earnings beat.
1. The slower growth of its gaming business
Tencent's total gaming revenue rose 17% year-over-year during the quarter and accounted for nearly a third of its top line. It attributed that growth to its top mobile games like Honor of Kings, PUBG Mobile, and Peacekeeper Elite, as well as newer games like Moonlight Blade Mobile.
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That growth rate was impressive, but it decelerated from the company's 29% growth in the fourth quarter and 45% growth in the third quarter. That slowdown wasn't surprising, since the company benefited from temporary stay-at-home tailwinds during the pandemic, but some investors likely expected a milder slowdown.
Tencent's gaming business also faces unpredictable headwinds, including playtime restrictions for minors in China, bans on PUBG Mobile in several countries, and recent national security concerns in the U.S. regarding its stakes in Riot Games, Epic Games, and other American companies.
2. Regulatory headwinds for its fintech business
After the Chinese government temporarily suspended new game approvals throughout most of 2018, Tencent launched a new fintech and business services segment to diversify its business away from games.
That business houses WeChat Pay, which holds a near-duopoly in China's digital payments market with Ant Group's AliPay; wealth management services; Tencent Cloud, the country's third-largest cloud infrastructure platform; and other enterprise-facing services.
Image source: Getty Images.
Tencent's fintech and business services revenue rose 47% year-over-year and accounted for 29% of its top line during the first quarter. That marked an acceleration from its 29% growth in the fourth quarter and 24% growth in the third quarter.
It attributed that growth to the resumption of big project deployments following the pandemic, robust demand from enterprise and online video customers, and its consolidation of Bitauto at the end of 2020.
However, China's antitrust regulators could still tighten their grip on WeChat Pay in the near future. They already want Ant Group, which is tightly tethered to Alibaba (BABA 0.76%), to restructure itself as a financial holding company that can be more easily regulated -- so Tencent could be next.
3. Other regulatory challenges in China and the U.S.
China's antitrust regulators could also pass new restrictions against WeChat, the most popular messaging app in China with over 1.2 billion monthly active users, in response to complaints about its walled garden blocking off access to competing third-party apps.
But that's not all. American regulators also recently passed a new law that will could delist U.S.-listed Chinese stocks -- including over-the-counter ADRs like Tencent -- if they don't comply with tighter auditing standards within the next three years. Those regulatory challenges on both sides of the Pacific are likely keeping the bulls at bay.
4. Pressure on its operating margins
Tencent's revenue growth across its other core businesses, including its online advertising and value-added services (which include in-app transactions in its games and non-gaming services) remains robust.
But its adjusted operating margin dipped year-over-year, from 33% to 32%. That contraction might seem minor, but it indicates Tencent is ramping up its investments again -- especially in lower-margin markets like cloud computing and streaming media -- as its revenue growth slows down. That's why analysts expect Tencent's revenue to rise 25% this year, but for its adjusted earnings to dip 6%.
5. The rotation from growth to value stocks
Based on that forecast, Tencent's stock trades at 33 times this year's earnings. That higher P/E ratio could expose it to the ongoing sell-off in pricier tech stocks, which has partly been caused by rising bond yields, inflation fears, and a preference for reopening plays over pandemic stocks.
That rotation has already been rough on American tech stocks, but it could be even more brutal for Chinese tech stocks, which face tougher regulatory headwinds in both China and the U.S.
The key takeaway
If you want to buy a Chinese tech stock, it might be better to stick with companies like JD.com and Baidu, which are both cheaper and face fewer regulatory headwinds. Tencent is more similar to Alibaba -- both companies own great long-term growth engines, but their stocks could be weighed down by high expectations and regulatory challenges for the foreseeable future.
