3 Red Flags for Tencent's Future

Tencent (TCEHY -0.94%) posted its second-quarter earnings report on Aug. 17. The Chinese tech giant's revenue dipped 3% year over year to 134 billion yuan ($20 billion), which missed analysts' expectations by 570 million yuan and was its first revenue decline since its IPO in 2004.

Its net profit fell 56% to 18.6 billion yuan ($2.8 billion), which missed analysts' estimates by 6.7 billion yuan. On an adjusted basis, which excludes its investments and other one-time items, its net profit declined 17% to 28.1 billion yuan ($4.2 billion). Those headline numbers were weak, but a closer look reveals three other bright red flags for its future.

Image source: Getty Images.

1. Its gaming business is struggling

Tencent is the largest video game publisher in the world, and that segment generated 32% of its total revenue (24% from domestic games and 8% from international games) during the second quarter.

Tencent started disclosing the growth of both markets separately in the third quarter of 2021. At first, its overseas growth offset the sluggish growth of its domestic business. But over the past year, its international gaming business also stalled out as the global gaming market grappled with difficult comparisons to its stay-at-home growth spurt during the depths of the pandemic.

Data source: Tencent. YOY = year over year.

Tencent's Honor of Kings is still the highest-grossing mobile game in China. But its popularity has also likely made Tencent a top target for government regulators, which throttled new gaming approvals and implemented tighter playtime restrictions for minors to address gaming addiction.

The Chinese government temporarily suspended new video game approvals last July as part of that initiative, then finally restarted the process this April. However, none of Tencent's latest games have been approved yet, which suggests it's being intentionally excluded to give smaller developers a chance to launch more games. Time is running out on that front: Tencent's revenue from Honor of Kings declined in the first quarter, and it desperately needs a new domestic hit to fill that growing void.

Tencent's international gaming business also faces regulatory challenges. Its battle royale game PUBG Mobile was banned in India due to national security concerns, and U.S. regulators have been taking a much closer look at Tencent's stakes in Riot Games, Epic Games, and other top publishers.

2. Its advertising segment is fizzling out

Tencent generated 14% of its revenue from its online advertising business -- which sells ads across WeChat, Tencent News, Tencent Video, and its other platforms -- during the second quarter. This segment was also once a core growth engine, but it ran out of steam over the past three quarters.

Data source: Tencent.

Tencent attributes that slowdown to sluggish ad spending across the internet services, online education, and finance sectors. Some of that deceleration was caused by macro headwinds -- including China's broader economic slowdown and intermittent COVID-19 lockdowns -- but some of it can also be attributed to the government's crackdown on those sectors and their ad spending.

To make matters worse, Tencent and many of its peers were recently forced to share their recommendation algorithms with the Chinese government to ensure their platforms promoted "positive energy." These rigid new restrictions could further hamper the ad segment's recovery.

3. Its fintech and cloud growth is stalling out

Tencent previously prioritized the expansion of its fintech and business services segment, which houses WeChat Pay and Tencent Cloud, to reduce its long-term dependence on video games. Unfortunately, this newer segment -- which generated 31% of its revenue during the second quarter -- also suffered a severe slowdown over the past year.

Data source: Tencent.

Tencent mainly blamed that slowdown on the impact of China's COVID lockdowns (mainly in April and May) on WeChat Pay's payment volumes.

But during the conference call, Tencent's chief strategy officer, James Mitchell, also admitted that the cloud business was struggling to grow as macro headwinds forced companies to curb their spending. He said that the division would focus on reining in its own cloud costs instead of trying to grow its market share against larger rivals like Alibaba and Huawei with "cutthroat pricing" strategies.

It's in the same boat as Alibaba

Analysts expect Tencent's revenue to rise just 2% this year as its net profit plunges 57%. That's a grim outlook for a company that once reliably generated double-digit revenue and earnings growth.

Tencent's stock might not seem expensive at 18 times next year's earnings. Alibaba, which faces similar challenges as Tencent, trades at 17 times next year's earnings. But both of these Chinese tech giants are still stuck in the same boat that's being hammered by macro and regulatory headwinds.

Unless Tencent shows clearer signs of a turnaround, I'd expect its stock to underperform the market given investors anticipate sluggish near-term growth for its gaming, advertising, fintech, and cloud businesses.