Nintendo (NTDOY 3.28%) and Tencent (TCEHY 3.71%) are two of the world's largest video game companies. Nintendo has produced popular video game consoles for nearly four decades, and its first-party franchises -- including Mario, Zelda, and Metroid -- are recognized worldwide.
Tencent, one of China's top tech companies, became a gaming juggernaut by developing some of the country's top mobile games -- including Honor of Kings and Peacekeeper Elite -- gobbling up overseas studios like Riot Games and Supercell, and investing in publishers like Epic Games, Activision Blizzard, and Ubisoft. Tencent is also Nintendo's distributor of Switch consoles and games in China.
Nintendo generates nearly all of its revenue from its consoles and games, which makes it a pure play on the gaming market. Tencent generated less than a third of its revenue from its gaming business last quarter, and the rest comes from its advertising, social networking, fintech, and cloud businesses.
Image source: Nintendo.
Over the past 12 months, Tencent's stock rose just 5% as regulatory concerns kept the bulls away. But during the same period, Nintendo's stock advanced nearly 30% as it shook off concerns about a post-pandemic slowdown. But can Nintendo remain ahead of Tencent for the rest of the year?
Tencent is stuck between a rock and a hard place
Tencent has diversified business interests. In addition to its massive gaming business, it serves over 1.2 billion monthly active users with WeChat, China's most popular messaging and Mini Programs platform, as well as hundreds of millions of streaming media users with Tencent Video, Tencent Music (TME 24.65%), and Huya (HUYA 9.39%). Its WeChat Pay platform holds a near-duopoly in the digital payments market with Ant Group's AliPay, and it owns the country's third-largest cloud infrastructure platform.
Tencent's revenue rose 28% in 2020, as its gaming, social networking, advertising, and fintech & business services segments all generated double-digit sales growth. Its adjusted net income rose 30%.
That momentum continued in the first quarter of 2021. Its revenue grew 25% year over year -- with double-digit growth across all its segments -- as its adjusted net income climbed 22%. Analysts expect its revenue and adjusted earnings to rise 23% and 21%, respectively, this year.
Tencent's stock isn't cheap at 35 times this year's earnings, and it could struggle to justify a higher valuation for several reasons.
First, Tencent could be China's next antitrust target following the government's recent crackdown on Alibaba. It's already been fined over several unapproved deals, WeChat Pay could face tighter regulations, and its planned merger of Huya and Douyu -- China's two largest video game streaming platforms -- will likely be blocked. Its apps could also be suspended to comply with new data collection laws in China.
To make matters worse, U.S. regulators plan to delist shares of Chinese companies that don't comply with new auditing standards within the next three years, and the Committee on Foreign Investment in the United States (CFIUS) has been probing Tencent's investments in U.S. gaming companies. All of those regulatory headwinds make it tough to buy Tencent right now.
Nintendo faces a cyclical slowdown -- for now
Nintendo's revenue soared 34% in fiscal 2020, which ended this March, as people bought more Switch consoles and games during the pandemic. Its Switch and software shipments both increased 37%.
The cheaper Switch Lite attracted more gamers, while popular games like Animal Crossing: New Horizons, Mario Kart 8 Deluxe, Ring Fit Adventure, Super Mario 3D All-Stars, and Super Mario 3D World + Bowser's Fury kept gamers engaged with their devices. Its net profit surged 86%.
But Nintendo faces two challenges this year. First, it expects its console and software sales to decline as the pandemic passes. The Switch is already more than four years old, and it could face fresh competition from newer consoles like the PS5 and Xbox Series S and X. Second, Nintendo expects the ongoing chip shortage to impact its production of new Switch consoles.
In May, Nintendo predicted its revenue and earnings would decline 9% and 29%, respectively, for the full year. It also disappointed investors in June when it didn't reveal its long-rumored "Switch Pro" at E3.
However, Nintendo recently revealed a new Switch model which sports an upgraded 7-inch OLED screen, an adjustable stand, and an upgrade dock with a built-in LAN port. This new device, which sounds a lot like the "Switch Pro," will launch alongside the long-awaited Metroid Dread this October.
Those catalysts -- along with new games like Super Mario Party Superstars, Pokemon Legends: Arceus, and HD remakes of The Legend of Zelda: Skyward Sword, Pokemon Brilliant Diamond, and Pokemon Shining Pearl -- might help Nintendo beat its own conservative estimates and set up firm foundations for the launch of a true "Switch 2." If that's the case, the stock still seems cheap at about 19 times forward earnings.
The winner: Nintendo
Tencent might initially seem like a better growth stock, but its regulatory headwinds are too fierce and unpredictable to ignore. Therefore, Nintendo is a safer overall investment, and it will likely continue to outperform Tencent and its Chinese tech peers throughout the rest of the year.
