Avoiding Huami OV, Tencent can't avoid the "Apple tax"

On August 14th, Tencent released its financial report for the second quarter of 2024. "Dungeon and Fighter: Origin" (hereinafter referred to as "DNF" mobile game), which broke away from the "hardcore alliance" of Android phone manufacturers, has become one of the main contributors to Tencent's strong performance.

Over a month ago, the "DNF" mobile game announced that due to the expiration of the contract, it would no longer be available on some Android platform app stores starting from June 20th, mainly including the four major manufacturers HuaMiOV. This is the first mobile game from Tencent to be removed from the Android channel.

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Now it seems that this "table-turning" move has not hindered the money-making ability of the "DNF" mobile game.

The financial report shows that in the second quarter of this year, Tencent's gaming revenue in the domestic and international markets reached 34.6 billion yuan and 13.9 billion yuan, respectively, with a year-on-year increase of 9%.

Among them, the gaming revenue in the domestic market has returned to year-on-year growth, and the total turnover growth rate exceeds the revenue growth rate, mainly thanks to the increase in revenue from the PC game "Valorant" and the release of the "DNF" mobile game. The "DNF" mobile game was launched at the end of May, with only 40 days of revenue included in Tencent's second-quarter performance, but the performance is very eye-catching.Additionally, mini-games based on the WeChat ecosystem have become a new growth point for Tencent's broad gaming business. In the second quarter, the total revenue of Tencent's mini-games increased by more than 30% year-on-year.

In the second quarter, Tencent's total revenue was 161.1 billion yuan, a year-on-year increase of 8%. Looking at the segments, the value-added services revenue, which includes gaming and social networking, was 78.8 billion yuan, a year-on-year increase of 6%; the online advertising business grew by 19% to 29.9 billion yuan; the financial technology and enterprise services business increased by 4% to 50.4 billion yuan.

In the previous quarter, Tencent's gross profit increased by 21% year-on-year to 85.9 billion yuan; according to non-IFRS (Non-International Financial Reporting Standards), the operating profit increased by 27% to 58.4 billion yuan, and the net profit attributable to the parent company increased by 53% to 57.3 billion yuan.

The gaming business, which contributes about 30% of the company's revenue, remains the mainstay of Tencent. The mobile game "DNF" soared to success without relying on Android distribution channels.

However, while Tencent has the strength to break away from the "hardcore alliance," it cannot avoid the "Apple tax."During the analyst conference call on the evening of August 14, Tencent's Chief Strategy Officer, Michelle, revealed that the company is in discussions with Apple regarding mini-games for the iOS platform, hoping to achieve this goal "on economically sustainable and fair terms."

"This discussion is ongoing. However, if there is no progress in the discussion, the current situation will continue. If the discussion makes progress, it may bring incremental benefits to us, to game developers, and possibly to Apple, and will certainly provide a better experience for Apple users," said Michelle.

Michelle also indicated that there is indeed a natural tension between the gaming industry and app stores, fundamentally due to the fees that app stores charge for games and other forms of digital content. The gaming industry believes that a 30% revenue share is a very heavy burden.

In the first half of this year, Apple repeatedly pressured Tencent and ByteDance to "plug loopholes," preventing mini-program operators from directing users to external payment systems to avoid the 30% Apple tax. Reports suggest that if Tencent and ByteDance do not fix these loopholes, the Apple App Store will refuse to allow subsequent updates for WeChat and TikTok.

At that time, neither company publicly responded to the matter. Tencent's mention of the issue this time shows a desire to negotiate a resolution with Apple, rather than adopting a "severing ties" stance against the hardcore alliance.This also implies that the thriving WeChat mini-games ecosystem may face the "Apple tax" in the future. Since Tencent does not personally develop mini-games, Apple's revenue sharing will not directly affect its performance; however, the increased operating costs for developers may hinder the rapid growth of the entire ecosystem, which could be detrimental to Tencent in the long run.

Nevertheless, for Tencent, retaining the large number of "Apple fans" with strong purchasing power is far more important than developing mini-games. After Apple used "stopping WeChat updates" as a bargaining chip, Tencent's choice between mini-games and Apple is clear, which is also in line with Tencent's strategic stance of maintaining rapid profit growth.

A

In last night's teleconference, regarding the decision for the "DNF" mobile game to bypass the "Hardcore Alliance," Tencent's management expressed "great satisfaction."

"We have decided to operate this particular game mainly through internal channels rather than Android app store channels. We are very satisfied with this decision. It is beneficial for our returns, and I believe it is also good in terms of user experience," said Michelle.He explained that Tencent made this decision, "given the influence of its IP, given that we know the most passionate players will look for and download the game through web addresses, whether or not it is in the Android app store."

However, Tencent does not plan to completely abandon third-party mobile game distribution channels from this point on. Michelle said that for other games with different characteristics that will be released in the future, if they need to start from scratch to gain users, "we look forward to continuing to cooperate with app store operators."

Faced with tough Android manufacturers, Tencent has not closed the door to cooperation. This indirectly shows that after a round of gamesmanship, Tencent is very likely to accept the "Apple tax" for small games.

In fact, even if Apple does not threaten to stop updating WeChat, Tencent cannot abandon Apple users.

As we all know, Apple iPhone users have a consumption willingness and ability that far exceeds that of Android phone users. In September last year, the well-known data research institution Asymco estimated in a report that the current average expenditure of iPhone users on APPs is 7.4 times that of Android users, a significant increase from the estimated 4 times ten years ago.Another perspective to observe is that the revenue ratio between Apple and Android channels for domestic mobile games is approximately 1:3. In contrast, in the second quarter of this year, the shipment volume of domestic Android phones was equivalent to six times that of Apple. Based on this rough estimation, the "whale" spending level of domestic iPhone players is about twice that of Android players.

High-value Apple users are the target players that Tencent needs to maintain most at present.

In the second quarter of this year, Tencent's gaming business finally warmed up: old IPs regained their youth, and mini-games maintained rapid growth. Both "old and young" are inseparable from Apple's iOS ecosystem.

Tencent disclosed in its financial report that last quarter, the revenue of the company's two flagship games, "Honor of Kings" and "Peacekeeper Elite," both returned to year-on-year growth; the "DNF" mobile game adapted from the PC game IP performed well, "activating millions of IP fans, and the player retention situation is good."

Tencent believes that the "DNF" mobile game has the potential to become the next "evergreen" game—a concept proposed by Tencent earlier this year. The standard for such games is a daily active user base of over 5 million (for PC games, 2 million), with an annual revenue of more than 4 billion yuan. According to calculations by Dolphin Research, the revenue of the "DNF" mobile game is expected to reach 20 billion yuan within 12 months after its launch.Mini-games fall under the category of "budding" sectors. In April of this year, WeChat disclosed some data on mini-games: in the first quarter, the DAU (Daily Active Users) grew by 20% year-on-year, and the MAU (Monthly Active Users) of IAA (In-App Advertising) mini-games reached 500 million, with developers exceeding 400,000.

In the second quarter, the revenue from mini-games saw a year-on-year increase of 30%. Unlike PC and mobile games, Tencent does not directly profit from mini-games but instead collects platform service fees. This portion of income, along with revenue from paid memberships for music, long videos, and sales of virtual items in mobile games, has driven a 2% year-on-year increase in Tencent's social network revenue and has boosted the gross profit of value-added services.

Previously, Tencent's gaming division had been lackluster for several consecutive quarters, with the domestic market performing particularly poorly. The impressive results in the second quarter have alleviated the pressure on the entire sector and signaled a return to a growth trajectory. Tencent cannot afford to abandon Apple, but how the negotiations surrounding the "Apple tax" proceed and what outcomes they achieve will have a significant impact on the future performance of mini-games and the entire gaming sector.

B

In the second quarter, among Tencent's three major business segments, only online advertising maintained a double-digit percentage year-on-year growth rate, increasing by 19.5% compared to the same period last year to 29.9 billion yuan, significantly leading the 6% growth in value-added services and the 4% growth in financial technology and enterprise services.However, when compared longitudinally, Tencent's advertising business growth rate in the last quarter was not particularly fast.

In the first quarter of this year, influenced by factors such as an increase in corporate marketing activities during the Spring Festival, Tencent's advertising revenue grew by 26.4% year-on-year. In the second quarter of last year, this revenue grew by 34.2% compared to the same period of the previous year, mainly due to the low base effect of the second quarter of 2022.

Internet advertising is greatly influenced by external environments and shows significant seasonal fluctuations. Coupled with the industry reaching its peak and the increasingly fierce competition among different platforms for advertisers' budgets, there is considerable uncertainty in the growth trajectory of internet companies' advertising businesses.

In the past few quarters, the biggest highlight of Tencent's online advertising segment has been the Video Account.

Before 2023, the primary task of the Video Account was to build infrastructure, improve products and technology, and cultivate user and creator ecosystems. Starting from 2023, the commercialization process of the Video Account has greatly accelerated, with advertising being the top priority.Tencent has released its video account advertising performance in various occasions. In the second quarter of last year, Tencent disclosed that the contribution of the video account to advertising business reached 3 billion yuan, accounting for more than 12%; in the third quarter, Tencent's financial report stated that the advertising income from the WeChat pan-internal cycle grew by more than 30% year-on-year, contributing to more than 50% of WeChat's advertising income, which includes landing page advertisements such as video accounts, mini-programs, and public accounts.

In the first quarter of this year, Tencent's advertising revenue grew by more than 26% year-on-year, driven by the growth of advertising and video accounts. In the second quarter financial report, Tencent stated that "the total user time spent on the video account has increased significantly year-on-year, thanks to the enhancement of the recommendation algorithm and more localized content," and this has partially driven the growth of advertising business revenue and profits.

Tencent's president, Martin Lau, mentioned "closed-loop advertising" in the financial report conference call, and this type of advertising is usually related to the video account. "We benefit from the adjustment of the proportion of various types of advertisements within WeChat, which are increasingly of a closed-loop nature. As you can see from large commercial platforms and short video services, closed-loop advertisements often achieve higher cost per thousand impressions (CPM) and higher click-through rates, whereas non-closed-loop advertisements do not."

The outside world has high expectations for the "money prospect" of the video account, and the key reason is that its advertising load rate is far lower than the industry average.

At the performance meeting in the third quarter of last year, Tencent disclosed that the advertising load rate of the video account was less than 3%, far lower than the 12% to 14% level of Douyin. This means that the video account can increase the density of information stream advertising by four times without overly affecting the user experience. At the beginning of this year, Guohai Securities calculated in a research report that the long-term space for video account advertising is expected to exceed 50 billion yuan.Additionally, merchants have opened small shops on Video Account and engaged in live-streaming sales, contributing to Tencent's technical service fee revenue. Last quarter, driven by this part of the income, Tencent's enterprise services business revenue achieved a growth rate of several percentage points, far exceeding the 4% year-on-year growth rate of financial technology and enterprise services.

As for the financial technology business centered around WeChat Pay, Tencent disclosed several data points during a conference call:

The number of payment transactions continues to grow at a double-digit percentage rate, but the average transaction amount has decreased; people wish to borrow more money, but Tencent actively controls the scale of lending, leading to a decrease in this part of the revenue; at the same time, as consumers' willingness to save strengthens, Tencent's financial management scale has increased. The interrelated data mentioned above serve as a footnote to the slow growth of the entire business segment.

In the first half of this year, among Tencent's three core indicators of users, revenue, and profit, only profit is still maintaining rapid growth.On the user front, in the first quarter, the combined MAU of WeChat and its overseas version was 1.359 billion, increasing to 1.371 billion in the second quarter, a sequential growth of 0.9% and a year-on-year increase of 3%. The mobile MAU of QQ was 553 million, growing by 3% to 571 million in the second quarter, remaining flat compared to the same period last year. It is not difficult to see that the user base of Tencent's two major user pools has essentially reached its peak.

Financially, in the past two quarters, Tencent's revenue grew by 6% and 8% year-on-year, respectively, which is a typical characteristic of a mature enterprise. Profits have maintained a strong momentum, with Non-IFRS attributable net profit to the parent company growing by 54% and 53% year-on-year, respectively.

The capital market has a positive attitude towards Tencent's performance in the first half of the year. So far this year, Tencent's stock price has accumulated an increase of over 26%; in contrast, among Chinese Internet companies with a market value of over one trillion yuan, Alibaba has risen by less than 5%, and Pinduoduo has fallen by nearly 3%.

In the face of slowing revenue growth, Tencent's profits continue to "soar," which is related to the long-term benefits brought by cost reduction and efficiency enhancement in the previous quarters.

Tencent disclosed in its financial report that in the second quarter, the company's cost of revenue decreased by 4% year-on-year to 75.2 billion yuan, due to the reduction in the cost of long video content and live broadcast revenue sharing, as well as the optimization of cloud project deployment costs.Now, Tencent's "cost reduction" has essentially come to an end.

Looking at the number of employees, Tencent's total headcount reached a peak of 112,000 in 2021, and fell back to 105,000 by June 2023. As of the end of June this year, Tencent had a total of 106,000 employees, an increase of 1,000 compared to the same period last year.

At the same time, Tencent is gradually increasing its expenditures. In the last quarter, Tencent's sales and marketing expenses increased by 10% year-on-year to 9.2 billion yuan; general and administrative expenses, including research and development costs, increased by 8% year-on-year to 27.5 billion yuan.

In the face of costs that are not easy to continue compressing, for Tencent to maintain a quarterly profit growth rate of over 50%, it needs to heavily invest in those businesses with substantial profits, such as gaming and advertising. Tencent's willingness to communicate around the "Apple tax" is also one of the means to safeguard the broader gaming business.

However, these two major sources of revenue, gaming and advertising, inherently carry significant uncertainty: as content-based products, whether games can remain evergreen and act as cash cows cannot be entirely based on past experiences, but rather have a somewhat "mystical" quality; advertising is closely related to the external environment, and changes in corporate budgets and consumer preferences can impact the entire industry.To minimize the uncertainty factors in financial reports, the fundamental solution for companies is to diversify their sources of revenue and tap into new profit springs. At Tencent, such businesses are referred to as "new shoots," with the most significant being the Video Account.

The advertising business of the Video Account still has vast potential, but it has not yet transcended the realm of online advertising. Its greater value lies in e-commerce, which has been a key focus of Tencent's efforts in recent times.

In the second quarter, the Video Account was very active around e-commerce, not only encouraging brands and merchants to participate in the 618 shopping festival but also launching the "Butterfly Project" to attract more influencers from outside the platform to start broadcasting. One of the outcomes of these efforts was that the entertainment star Christy Chung's live streaming sales event attracted over ten million viewers, setting a new record for live streaming sales on the Video Account.

At the same time, the Video Account is undergoing organizational restructuring. At the end of May, the Video Account's live e-commerce team was integrated into the WeChat Open Platform team, reporting to the latter's head. This is equivalent to elevating the management level of the Video Account's live e-commerce.

This week, Tencent announced that it will upgrade the Video Account's mini-stores to WeChat Stores, which will not only lower the barriers and simplify the process for merchants to set up shop but will also support the circulation of store and product information within multiple WeChat scenarios, including public accounts (subscription accounts, service accounts), Video Accounts (live streaming, short videos), mini-programs, and search functions.However, overall, the video account e-commerce is still in its infancy.

In terms of scale, according to different sources of information, the GMV of video account e-commerce in 2023 is between 100 billion and 300 billion, which is an order of magnitude difference compared to the more than 200 billion of Douyin e-commerce. There are reasons for the late start of video account e-commerce, and the short user usage time and the high proportion of white-label products are also factors that cannot be ignored.

As for another highly watched "new bud" - AI large models, Tencent did not elaborate much in the second quarter financial report.

The financial report stated that based on the Hunyuan basic model, the company launched the AI assistant "Yuanbao", "which has a competitive advantage in accurate image understanding, advanced natural language processing, and AI search enhanced by our unique content ecosystem."

"When Yuanbao reaches a certain level, we will increase promotional resources and try to let more users use the application. When it reaches a more excellent professional level, it can start to be integrated into various parts of the Tencent ecosystem." Liu Chi-Ping said in a conference call.

The two "new buds" of video accounts and AI models still need to grow, and model games and advertisements are the key to Tencent's second quarter to stabilize its position. However, only when the "new buds" mature can Tencent narrow the significant gap between profit and revenue growth, and re-establish the growth cycle of users - revenue - profit.