Tencent Holdings Limited (OTCPK:TCEHY) Q1 2022 Earnings Conference Call May 18, 2022 8:00 AM ET
Wendy Huang – Investor Relations
Pony Ma – Chairman & Chief Executive Officer
Martin Lau – President
James Mitchell – Chief Strategy Officer
John Lo – Chief Financial Officer
Conference Call Participants
Alicia Yap – Citigroup
Eddie Leung – Bank of America
Ronald Keung – Goldman Sachs
William Packer – BNP Paribas
Charlene Liu – HSBC
Jerry Liu – UBS
John Choi – Daiwa
Gary Yu – Morgan Stanley
Elinor Leung – CLSA
Alex Yao – JPMorgan
Good day, and thank you for standing by. Welcome to Tencent Holdings Limited 2022 First Quarter Results Announcement Conference Call. At this time, all participants are in listen-only mode. After speakers’ presentation, there will be a question-and-answer session. [Operator Instructions] And please be advised that today’s conference is being recorded. [Operator Instructions]
And now, I would like to turn the conference over to Ms. Wendy Huang from Tencent IR team. Thank you. Please, go ahead.
Thank you, Operator. Good evening. Welcome to our 2022 first quarter results conference call. Before we start the presentation, we would like to remind you that it includes forward-looking statements, which are underlined by a number of risks and uncertainties and may — realized in the future for various reasons. Information about general market conditions is coming from a variety of sources outside of Tencent.
This presentation also contains some unaudited non-IFRS financial measures that should be considered in addition to, but not as a substitute for, measures of the group’s financial performance prepared in accordance with IFRS. For a detailed discussion of risk factors and non-IFRS measures, please refer to our disclosure documents on the IR section of our website.
Let me introduce the management team on the call tonight. Our Chairman and CEO, Pony Ma, will kick off with a short overview; President, Martin Lau; and Chief Strategy Officer, James Mitchell, will provide a business review; Chief Financial Officer, John Lo, will conclude with financial discussion, before we open the floor for questions.
I will now turn the call over to Pony.
Wendy, good evening. Thanks everyone for joining us. During the challenging first quarter of 2022, we implement cost control initiatives and rationalized certain non-core businesses, which will enable us to achieve a more optimized cost structure going forward. We utilized tools such as Mini Programs, Tencent Meeting and WeCom to help enterprises and consumers with the resurgence of — in China and continue investing in strategic growth areas including enterprise software, Video Account and international games. Looking forward, we will sharpen our focus and sustain our innovation through challenges and cycles, and continue to — value for our users, partners and society.
Now let me go through the headline financial numbers for the quarter. Total revenue was RMB135 billion largely stable year-on-year or down 6% quarter-on-quarter. Gross profit was RMB57 billion, down 9% year-on-year and 1% quarter-on-quarter. Non-IFRS operating profit was RMB37 billion, down 15% year-on-year or up 10% quarter-on-quarter. Non-IFRS net profit attributable to equity holders was RMB26 billion, down 23% year-on-year or up 3% quarter-on-quarter.
For our key services, we generally retain our second place positions in activities, including social games, long-form video, news, music, literature, payment and mobile browser. Combined MAU of Weixin and retail was 1.29 billion. Mobile devices MAU of QQ was 564 million.
Now I will hand over to Martin and James for the business review.
Thank you, Pony, and good evening and good morning to everybody. For the first quarter of 2022, our total revenue was largely stable year-on-year. VAS represented 54% of our total revenue within, which social networks sub-segment revenue was 22%, domestic games sub-segment revenue was 24%, and international games sub-segment was — online advertising was 13% and FinTech and Business Services was 32% of total revenue.
For Value-added Services, the segment revenue was RMB73 billion for the quarter, broadly stable year-on-year. Social networks revenue was up 1% year-on-year to RMB29 billion, reflecting increased revenue from video accounts like streaming service, which was largely — revenue from music and games-related live streaming services.
Total VAS subscriptions grew 6% year-on-year to 239 million. For Tencent Video, we extended long video market leadership with 124 million subscribers. Our popular content such as drama series Sword Snow Stride and animated series Perfect World Season 2, demonstrated our strength in IP adaptation of comics and novels.
Music subs increased 32% year-on-year to 80 million driven by high-quality content as well as increased consumer willingness to subscribe for music services. Domestic games revenue was down 1% year-on-year to RMB33 billion as direct and indirect effects of minor protection measures impacted active user and paying user accounts.
Recently released games, League of Legends: Wild Rift and Fight of The Golden Spatula generated incremental revenue. While revenue from Moonlight Blade Mobile and Call of Duty Mobile decreased.
International Games revenue grew 4% year-on-year to RMB11 billion. Year-on-year growth was slower than in recent quarters, reflecting lower PUBG Mobile revenue as user spending normalized the post-COVID industry-wide as well as timing of content upgrade in League of Legends and Clash of Clans. Revenue declined — base in fourth quarter last year when there was a trued-up adjustment to Supercell’s revenue and more consumption during the year-end holidays.
With respect to Weixin Video Accounts continued its strong growth momentum with significant year-on-year increase in video viewers and time spent. This was supported by expansion in news, knowledge-based and entertainment content as well as better recommendation technologies. We also — enterprise messaging and shopping features in Video Accounts to facilitate user engagement and monetization for creators, driving a more vibrant content ecosystem.
Mini Programs exceeded 500 million DAUs and sustained rapid growth in GMV year-on-year, with particularly notable growth in retail and restaurant categories as we enhance the functionalities for customer services and operational analysis. With more public — such as health and municipal services available through Mini Programs, we’re able to cultivate user habits in accessing essential services through Mini Programs.
For QQ, we are enriching features for young users to better create share and connect with each other. We provide avatar tools for users to create interesting short videos, featuring their own customized Super QQ Show characters. Through a status update users can share videos music they are consuming, so that their friends can access and stream the same content without leaving the QQ app via Mini Programs, enhancing social interaction and content consumption.
Turning to domestic games, we extended our long-standing leadership among the highest DAU games while also penetrating new and new to Tencent game genres. In battle arena games, Honour of King’s growth in receipts decreased year-on-year during the Chinese New Year holidays due to fewer commercially successful items. However, the game’s adult user base has been stable and growth in receipts resumed year-on-year growth in March on more commercially successful items.
Peacekeeper Elite the number one shooter game in China enhanced its user engagement by introducing new combat items and battlefield design in its third anniversary content update in April.
Among new genres in auto battler games Fight of The Golden Spatula released new champions and game mechanics that enriched players’ competitive experience. The game ranked number one in the genre and number six in all mobile games by DAU in the first quarter. It is currently the most successful new game release across the industry from 2021.
In real-time strategy games, we launched Timi Studio’s Return to Empire in late March. Leveraging partnership with Xbox Game Studios, the game offers high-quality graphics and contents to gamers. It was the second most revenue-generated game in the genre industry-wide measured by grossing receipts in April.
Moving on to International games. The mobile game industry outside of China generally experienced slower growth or declines in early 2022 versus COVID-19 period in early 2021. PUBG Mobile as a result experienced year-on-year growth in receipts decline in the first quarter. However, we’re confident in the game’s longer-term trends, as they move beyond the COVID comparisons.
Spider-Man-themed PUBG game was launched in January and was successful in driving user engagement. While Lamborghini timings released in March became the game’s top-selling cars games ever.
Our PC game Valorant continued its robust performance. Its growing user base paying propensity and attractive content drove growth in receipts up significantly year-on-year. Valorant has become the sixth most popular PC game by MAU across all genres and is the highest ranked in new PC game title released in the last four years.
Besides our existing titles, we’re releasing compelling new games via partnership with globally renowned IPs. One example is Dune: Spice Wars, a real-time strategy PC game based on the sci-fi IP Dune. Published by our subsidiary studio Funcom, the game achieved initial success since its early access launch on April 26.
Funcom which has game rights to notable IP such as Dune and Conan, the Barbarian is also developing an open world survival game based on Dune. Another example is Apex Legends Mobile, a hero shooter battle royale game jointly developed by our Lightspeed & Quantum Studios and EA’s Respawn studio, was launched yesterday globally. The mobile game is based on one of the most successful new PC console IPs in recent years. Looking forward, we aim to grow further our existing titles and release multiple big budget new titles especially from 2023 onwards.
With that, I’ll pass to James to talk about other businesses.
Thank you Martin. Turning to Online Advertising, revenue was RMB18 billion in the first quarter down 18% year-on-year and down 16% quarter-on-quarter and subdued bidding density results in lower eCPMs. Our Social and Others Advertising revenue was RMB16 billion down 15% year-on-year and 15% quarter-on-quarter, within which our mobile ad network revenue declined sharply year-on-year due to weak demand and regulatory changes such as restrictions on flash screen ads.
Weixin Moments advertising revenue dipped slightly year-on-year as weakness in education and real estate ad spend outweighed growth from FMCG and games ad spend. Official Accounts advertising revenue increased notably year-on-year as we enabled advertisers to better target young users via notification of feeds ads and to run their ads within an environment of high-quality and relevant content.
Over 20% of Official Accounts ad revenue comes from click-to-purchase and click-to-message ads, which are powered by Mini Programs and WeCom respectively.
Our Media Advertising revenue was RMB2 billion down 30% year-on-year, and 27% quarter-on-quarter. Within which our video ad revenue declined double digits year-on-year. The Winter Olympics and popular drama series, such as The Oath of Love generated incremental video ad revenue but were more than offset by fewer releases of top-tier variety shows when compared to the first quarter of last year.
For the second quarter to date, advertising categories such as FMCG eCommerce and travel have scaled back their spending due to the COVID situation and attend to supply chain disruptions. We continue to invest in our advertising system, and are upgrading our machine learning infrastructure to process data more efficiently. The upgrade should ultimately enable us to enhance our targeting and thus conversion rates for advertisers.
Looking at FinTech and Business Services. Segment revenue was RMB43 billion, up 10% year-on-year and down 11% quarter-on-quarter. To FinTech, the year-on-year revenue growth moderated due to slower growth in commercial payment volume reflecting multiple cities taking measures to combat the COVID-19 resurgence in March resulting in less consumption of both, everyday items such as food and beverage, as well as big-ticket items such as travel booking.
Our payment volume correspondingly decelerated especially in categories such as transportation dining services and apparel. For Business Services, our revenue dipped slightly year-on-year as we shifted our focus from prioritizing revenue growth toward customer value creation and quality of growth.
We proactively scaled back certain loss-making activities such as projects that carry substantial headline revenue, but also substantial costs that, we needed to pay to subcontractors, as well as deeply discounted infrastructure-only contracts for basic services such as cloud compute and content delivery network. However, we’ve increased our healthier margin PaaS revenue, especially in video, cloud and cybersecurity.
The video cloud taking advantage of our accumulated experience providing in-house interactive entertainment and video chat services, as well as our low latency network infrastructure. We’re increasingly migrating, our clients from basic Content Delivery Network to more sophisticated video-on-demand, live streaming and real-time communication solutions.
Our real-time communication service meets growing demand interactive video services, in scenarios such as online meetings, customer service and live streaming eCommerce. And Gartner ranked Tencent first among all vendors for Communication PaaS revenues in China for 2021.
For cybersecurity we expanded our client base across network, endpoint and business operation security solutions, fulfilling enterprises’ needs for protection against cyber-attacks as well as for cybersecurity compliance.
To position for the fast-growing demand for next-generation enterprise security, we’re enhancing our Zero Trust security solutions that facilitate remote working. — Trust security solutions leverage our accumulated internal experience in network security management.
And I’ll now pass to John.
Thank you, James. For the first quarter of 2022, total revenue was RMB135.5 billion stable year-on-year or down 6% quarter-on-quarter. Gross profit was RMB57.1 billion down 9% year-on-year or 1% quarter-on-quarter.
Net other gains were RMB13.1 billion, down 33% year-on-year or 85% quarter-on-quarter, which were primarily non-IFRS adjustment items including RMB18.5 billion gain arising from our partial divestment of Sea Limited, partly offset by impairment provisions against investee companies in verticals such as transportation services and online media.
Operating profit was RMB37.2 billion, down 34% year-on-year and 66% quarter-on-quarter. Net finance costs were RMB1.9 billion, up 42% year-on-year or 4% quarter-on-quarter, reflecting greater interest expenses due to increased indebtedness as well as lower foreign exchange gains both year-on-year and quarter-on-quarter.
Shared of losses of associates and JVs were RMB6.3 billion compared to share of profits of RMB1.3 billion last year. Non-IFRS share of losses were RMB2.2 billion, compared to non-IFRS share of profits of RMB0.5 billion a year ago, reflecting revenue decline at certain overseas game associates due to post-COVID user spending normalization, losses recognized from associates in the transportation services verticals and the impact from JD.com ceasing to be an associate.
Income tax expense decreased by 27% to RMB5.3 billion, for the first quarter — 2022 on a year-on-year basis. The effective tax rate was 18.2%. IFRS net profit attributable to equity holders was RMB23.4 billion, down 51% year-on-year or 75% quarter-on-quarter. Diluted EPS was RMB2.404, down 51% year-on-year or 75% quarter-on-quarter.
Now, I’ll share with you our non-IFRS financial figures. Operating profit was RMB36.5 billion, down 15% year-on-year or up 10% quarter-on-quarter, reflecting lower marketing expenses as a result of our cost optimization measures. Net profit attributable to equity holders was RMB25.5 billion, down 23% year-on-year or up 3% quarter-on-quarter. Diluted EPS was RMB2.62, down 23% year-on-year or up 3% quarter-on-quarter.
Moving on to gross margin, the overall gross margin was 42.1%, down 4.2 percentage points year-on-year or up two percentage points quarter-on-quarter. The year-on-year decrease reflected the result of stable revenue with — operating costs mix shift towards lower-margin products and our continued investments in key strategic initiatives. The quarter-on-quarter increase was due to seasonal revenue mix shift towards high-margin businesses such as games.
By segment, gross margin for VAS was 50.4%, down 4.7 percentage points year-on-year or up 1.7 percentage points quarter-on-quarter. The year-on-year decrease reflected — revenue with increased costs including content cost for games, server and bandwidth costs, in addition to our investment in strategic initiatives in particular Video Accounts.
The quarter-on-quarter increase was driven by seasonal revenue mix shift towards higher-margin businesses within the segment. Gross margin for Online Advertising was 36.7% down 8.4 percentage points year-on-year or six percentage points quarter-on-quarter.
Year-on-year decrease was due to revenue decline and increase in operating costs, including those associated with our Video Accounts and the content cost of Beijing Winter Olympics as well as the fact that the full exemption from cultural construction fee was no longer available this year, which was also the main reason for quarter-on-quarter decrease.
Gross margin for FinTech and Business Services was 31.6% broadly stable year-on-year up 4.5 percentage points quarter-on-quarter. The quarter-on-quarter increase was driven by revenue mix shift towards higher-margin FinTech businesses within this segment as well as our recent initiatives to reduce loss-making cloud service contracts.
On operating expenses. Selling and marketing expenses were RMB 8.1 billion down 6% year-on-year or 31% quarter-on-quarter, excluding stock-based compensation. Selling and marketing expenses decreased by 7% year-on-year and 32% quarter-on-quarter.
Y-on-Y decrease reflected our marketing expense optimization measures. Quarter-on-quarter decrease reflected lower marketing spending on games and Business Services due to both seasonality and expense optimization measures. Selling and marketing expenses were 5.9% of revenues broadly stable year-on-year.
R&D expenses were RMB 15.4 billion up 36% year-on-year or 10% quarter-on-quarter. Excluding share-based compensation, R&D expenses increased by 27% year-on-year or 6% quarter-on-quarter. The year-on-year and quarter-on-quarter increases were mainly due to greater staff costs reflecting our ongoing investment in key strategic initiatives as well as the impact of recent acquisition of subsidiaries.
R&D expenses were 11.4% of revenues. G&A expenses excluding R&D were RMB 11.3 billion up 47% Y-on-Y or 9% Q-on-Q. Excluding share-based compensation, G&A expenses — excluding R&D increased 25% year-on-year or decreased 7% quarter-on-quarter.
The year-on-year increase reflected greater staff costs driven by headcount increase to support our ongoing investment in key strategic areas, greater expenses incurred by our overseas subsidiaries as well as expenses from recently acquired subsidiaries. At quarter end, we had approximately 116,000 employees up 30% year-on-year or 3% quarter-on-quarter.
Let’s take a look at the operating and net margin ratios — reasons I mentioned earlier non-IFRS operating margin was 27% down 4.6 percentage points year-on-year or up four percentage points quarter-on-quarter. Non-IFRS net margin was 19.4% down 6.1 percentage points year-on-year due to lower operating margin and the turning from profit to losses share from associates as a whole. Non-IFRS net margin increased by 1.5 percentage points quarter-on-quarter due to seasonal revenue mix shift to higher-margin businesses as well as marketing expenses optimization measures.
Finally, I’ll share some key financial metrics on the cash flow and balance sheet for the quarter. Total CapEx was RMB 7 billion down 10% year-on-year or 40% quarter-on-quarter. Within total CapEx, operating CapEx was RMB 5.2 billion down 21% year-on-year. Non-operating CapEx — by 54% year-on-year to RMB 1.8 billion.
Operating cash flow for the quarter was RMB 33.8 billion down 34% both year-on-year and Q-on-Q. Year-on-year decline amongst normal working capital change was partly due to lower cash receipts from games and Online Advertising, while our R&D and staff cost continue to grow.
Quarter-on-quarter decline was primarily due to our annual — recorded in the first quarter each year. Free cash flow for the quarter was RMB 15.2 billion down 54% year-on-year and 54% — 55% quarter-on-quarter. Net debt position was RMB 11 billion compared to RMB 20.2 billion last quarter.
The fair value of our shareholdings and listed investee companies excluding subsidiaries was approximately RMB606 billion or US$95 billion as of the end of the quarter. We repurchased approximately 8.9 million shares with about RMB3 billion for the quarter. Thank you.
Operator, let’s open the floor for questions now.
Thank you. Your first question comes from the Alicia Yap from Citigroup. Your line is now open. Please go ahead.
Hi. Thank you. Good evening, management. Thanks for taking my question. My first question is that in light of the latest situation in China, so can management share with us your insight on what you have been able to observe over the past two month in terms of any change of the consumer behavior or your partners’ sentiment as related to your digital content consumption, the consumer willingness to spend and then your business partner on the online ad budget spend and also the cloud infrastructure migration timing given the latest lockdown? So how will the latest macro headwind affect your gaming payment, advertising or even your cloud business outlook into the second half?
And then my second question is can management elaborate a little bit on your prepared remarks related to your video on-demand live streaming and also the real-time communication solution? So how will that – these advanced solutions translate to a better pricing eventually that also will help you optimizing your operating costs that could potentially support future business revenue – business service revenue growth and also — for this segment? You mentioned some customer adoption rate. Any color that you can share on this on-demand service so far? Thank you.
Alicia, thank you for the two questions. And there are a number of sub-questions within them but I’ll try to cover up most of the topics you raised. So in terms of observations on changing consumer and enterprise sentiment then at a high-level generalization the behavior is very tied to the COVID situation in different cities around China. So as you’re probably all aware, Shanghai has experienced a very severely unfortunate COVID outbreak. And we have seen on the consumer side that the commercial payment volume has remained below trend and down year-on-year for many weeks in Shanghai. The trend is gently improving now, but it’s still below where it would otherwise be.
On the other hand Shenzhen provides a case study of a city that had a small-scale COVID outbreak in March and got on top of it very quickly. And if we look at the consumer commercial payment volume in Shenzhen there was a sharp let in March with the lockdowns and then a fairly rapid recovery in April. And in May, the commercial payment volume is largely back to the previous trend rates and growing year-on-year in Shenzhen. So in terms of how will the latest macro headwind affect our businesses, it’s really a question, primarily of how COVID behaves in different cities across the country.
Drilling into some of your sub-questions. On the digital content side then if I were to differentiate the COVID outbreaks in 2022 versus those we previously experienced in 2020, what we saw in early 2020 was that because the COVID outbreaks happened straight after the Chinese New Year period many people were in a patient mindset, holiday mindset and they remained in a holiday mindset during the lockdown. And so there was a relatively fast upturn in usage of entertainment-related applications.
On the other hand, it took consumers and enterprises and teachers and students several weeks to become comfortable with productivity-related applications. This time around the COVID outbreak happened, — after the Chinese New Year holiday and so people were generally back at work, back at school and they sought to continue working or studying but from home. And so we saw a slower uptake of entertainment-related applications, but a much faster uptake of productivity-related applications such as Tencent Meeting.
And I think that that accelerated uptake, in productivity applications reflects first of all the fact that, many more enterprises and consumers and educational establishments are now familiar with how to use Tencent Meeting and WeCom’s [ph] Tencent documents. And secondly, the fact that a number of our enterprise software services in particular, the Tencent Meeting have boosted their market share substantially over the past two years. So that’s on the digital content.
In terms of, how will the macro headwind — specific businesses unfortunately COVID is affecting negatively most people in China, particularly in the affected cities. And we’re not exempt from that. So I think, that the negative impact is particularly notable on advertising, partly because of the overall pressure on GDP, partly because many companies especially multinationals, run their marketing budgets — Shanghai.
And then there’s some impact on our payment volumes as I mentioned, although, that’s more differentiated city by city rather than universal nationwide. Some negative impact on cloud project launches, and then harder to see the impact on the game business. So I hope that covers off your, first question.
On the second question, around the — on-demand opportunity. Then, in general our belief is that over time customers are migrating from barebones content delivery network, toward a more sophisticated real-time video communications and ultimately toward integrated communications platform-as-a-service solutions. And as they migrate, the competitive barriers to entry become — and the margins correspondingly become healthier.
So starting with content delivery network, there are many companies in China that are reselling telco bandwidth for CDN. We have some competitive advantage in, that we have a very substantial in-house infrastructure including lease lines that we actually own and operate. But frankly, it is a somewhat commoditized business. It’s prone to price wars and margin compression.
As you move to real-time video, then there’s only a handful of companies that have the algorithms, in order to provide low-latency video solutions. And we’re one of them, because we have the unique advantage of having supported billions of video chats for Weixin and QQ users for many years.
And then as you move into communication platform-as-a-service, I think we’re somewhat uniquely advantaged in that there are many enterprises — salespeople are individually using Weixin any way to communicate with their customers. And so it’s very natural, for the enterprises to then aggregate those salespersons customer relationships through the WeCom software and ultimately systematize with their provision of video chat, video communication within WeCom.
In terms of the customer adoption rate, then I think both globally and in China, we’re very optimistic about the trends we see and the trends we expect to see in the future. If you think about how corporations interact with consumers online, initially they did it just by operating a website. They would include a telephone number. Then they facilitated e-mail within the website. Then consumers wanted to move to a live chat.
And in the future, I think it’s an inevitability that many consumers for many products, will want to move from message chat to a video chat. And so for companies being able to provide low-latency real-time video interaction with the consumers, will just become a cost of — a necessary cost of doing business, and a key competitive tool. So we’re optimistic about communication platform-as-a-service, and about low-latency real-time communications now and for the future.
Great. Thank you. Our next question comes from Eddie Leung from Bank of America. Please ask your question.
Good evening guys. I have a question on your new cloud strategy. Just wondering if the changes will have any indication on the mix of your clients going forward, will that change the mix of clients in terms of vertical industries the size of your clients as well as the sophistication of your clients?
Well, I think that cloud services in China is a little bit dissimilar from cloud services in the Western world in that historically and currently about 50% of revenue industry-wide is from other Internet companies, and 50% is from all sorts of primarily initially offline businesses, such as financial services, such as manufacturing, such as government and local services. And our shift is not intended to necessarily change that current demand reality.
But I think that the shift is necessary in order to provide services cost effectively, and therefore, attractively to the offline first businesses that are moving online, because at the moment in China and this was true in the West a few years ago, there’s a propensity for companies for cloud vendors to — in a very customized very cost heavy solution, so really to act as more as a system solution providers or IT consultancy services.
And while that is achievable in an environment of kind of infinite capital, it’s not scalable, I mean, it’s not sustainable. And therefore, it’s not where the long-term growth will come from. So we have made a proactive decision that we are focusing on scalable, and therefore, sustainable and profitable opportunities.
And I think if you look at the West, it’s been very hard for companies that try to do both to be successful at both. Generally, if you’re still in the project deployment industry then that remains your bread and butter versus those companies that have gone all-in on truly cloud based solutions have been the ones that have benefited most from the changing industry profile.
So we have a big chunk of our revenue from other Internet companies and that will continue, but in the long-term the greater growth will come from a whole range of other industries. And we have roughly half of our revenue within that segment from infrastructure and the other half from platform software and industry solutions and we aspire to grow both, but particularly the latter.
Thank you. Our next question comes from Ronald Keung from Goldman Sachs. Please ask your question.
Thank you. Thank you, Pony, Martin, James and John. I want to ask about our Online Advertising. So with the COVID lockdowns and consumption worsened into second quarter, I just want to hear how management thinks about the online advertising growth and maybe potential — stabilization or some forms of inflection. I think taking into different drivers like macro across different verticals easier base for some of the verticals and any potential video account monetization in that? Thank you.
Yes. Thank you. So what we’ve said in previous calls was that as we moved into the second half of 2022 then all our SQL advertising trends should inflect positively, because first of all, we’ll lap a number of discrete regulatory changes both affecting our advertisers and also affecting our own advertising media. And then secondly, because over time, we will bring onstream additional inventory including the video accounts.
The new factor since we last spoke has been the outbreak of COVID in a number of locations, depending how quickly COVID is brought under control will determine whether our previous comments still holds true or whether the timetable gets pushed back, because again the COVID is hurting consumption, which is unhelpful. It’s also hurting logistics especially through logistics through Shanghai, which is a logistics hub, which is more unhelpful. And then finally, it is impacting the city in China where most multinationals actually have their headquarters and to make their marketing decisions which is further unhelpful.
Thank you. Our next question comes from William Packer from BNP Paribas. Please go ahead.
Hi management and many thanks for taking my questions. Firstly, we’ve had lots of comments recently from various authorities talking to both the healthy development of the platform economy in addition to completion of rectification in recent weeks. Could you help us understand, how you think of those two important objectives and the implications for Tencent? And then secondly, operating cost growth slowed in Q1 relative to recent quarters, demonstrating good cost control. Could you help us think through the trajectory of cost growth over the rest of the year and the key…
Okay. I’ll take the first question. It is true that in the past two months, the Chinese government has actually released quite a bit of supported signals towards digital economy and platform economy at the top level. In particular, I would point to yesterday in a PCC meeting, Chairman Wang Yang stated clearly to support stronger and high-quality, as well as larger-scale digital economy. And Vice Premier Liu He also reiterated the intention to firmly support platform economy, as well as private economy.
And I think that’s consistent with last month as of the end of last month April 29, when the politburo meeting convened and it stated the intention to foster a healthy development of the platform economy and to complete ratification actions on the platform economy to implement a normalized deregulation and also to introduce specific measures to support healthy and compliance growth of the platform economy. So we can clearly see that from the senior-most level there is a pretty clear supportive signals released.
But I think for this to translate into a real impact on our business, there is going to be a time lag in process. I would say, it would take time for the specific regulators and ministries to translate this direction into real actions. And I think in the politburo — it’s pretty clear to state the sequence, right? There is a completion of the ratification actions and then, they implement normalized deregulation and then introduce specific measures to support.
While we would not be expecting these three actions to be specifically sequential, I would say, the sequence is pretty much in that order. So, it will — time for the corrective measures to be turning into normalized regulation and then the specific supported measures would be introduced. So, we would be working closely with the regulators and hope to see this transition to happen. And I think a positive development is that, in April, the publishing bill — to approve BanHao, the publishing licenses for games. And it’s definitely an encouraging sign. And we felt when the transition continue to happen then, the compliance and also well-behaving companies would start to benefit.
Hi Will. On the cost growth, let me break it into sort of four categories. So first of all, you can see in the first quarter that our sales and marketing expense growth — which is good for us. It’s a little bit of a double-edged sword in that a number of other Internet companies have also slowed their sales and marketing spend which has impact on our advertising revenue, but it is something that we can control relatively quickly and we have controlled relatively quickly.
A second bucket is around our general and admin expenses which are largely tied to headcount and cost per head. And in the first quarter for a number of reasons those general and admin expenses continue to grow at a rapid rate. However, you can see that our headcount growth is slowing down. The heads we’re adding are generally speaking often lower-cost heads. And in general, our cost per head is also decelerating. So, as we work through this year, we should expect the G&A expenses to decelerate.
The third bucket is around the cost of sales and the impact on gross margin. And within this bucket, there are some actions we’re taking for example managing costs within a Tencent Video that may take a few months to flow through. There’s other actions such as exiting some of the lower-margin Business Services activity where would we see the benefits sooner.
And then finally and easy to forget is that to get to our net income, you run through associate item and associate contributions have moved from a profit to a loss year-on-year. And one of the biggest reasons for that is simply that a number of our big associates in which we have substantial stakes, ramped up their community group buying initiatives in the last year.
So, if you add it all up, if investee A spent RMBX billion on community group buying and we’re actually accounting 15% of that loss. And investee B spent RMVX billion on community group buying and where our associated accounting 12% of that loss and so on and so on. Then in a way our associate income line effectively is a community group buying business all by itself because you add up multiple companies at 10%, 15%, 20% stakes and get to something that looks like our own community group buying business.
And as you may be aware those companies who were investing very aggressively in community group buying in the last 12 months have now fairly sharply slowed down that investment. And that will start flowing through their P&Ls and therefore also through our P&L via the associate income line. So, those are four buckets within the cost discussion to think about. Thank you.
Thank you. Our next question comes from Charlene Liu from HSBC. Please go ahead. Thank you.
Thank you very much for the opportunity. I would like to ask a question regarding the gross margin for the advertising business. We saw that — I just wanted to get a sense on obviously based on the various ad products are we seeing — sorry, sorry. I apologize. I think across various ad products, we wanted to get a sense on which are we going to see maybe faster or slower recovery? And how would that shift affect the Online Advertising CPM going forward? Because I think it came in a bit slower versus — came in a bit lower versus our expectations. I apologize for the noise again.
No problem about the noise. Now, I think in terms of the advertising results for the quarter then it’s worth being aware the Olympics — the Winter Olympics cost us hundreds of millions of renminbi between the sort of broadcast rights and the actual operating expenses around it. And that’s a low-margin activity that has a negative impact on the blended advertising gross margin.
And then as we spoke about in Q4, the Video Accounts growth translates at the moment into more cost than revenue impact. And for better or worse Video Accounts continue to grow video views very quickly in Q1. And so some of that flows through into the advertising segment costs.
So, looking forward what happens with Video Accounts monetization will be an important driver of how incremental margins behave for the advertising business. Beyond that within advertising, we have a mix of owned and operated properties that are inherently high margin like moments in Video Accounts, owned and operated properties that are lower margin such as our media services and then the ad network business that is inherently low margin.
And so depending how our growth pans out between those three categories, it will have a big impact on the blended gross margin. And that in turn is a function of which advertiser categories rebound the fastest because certain advertiser categories like luxury goods for example is skewed towards the high-margin owned and operated properties than other categories such as e-commerce may skew towards low-margin ad network. It also depends on the impact of the advertising system changes we’re putting through which may show up different times for different inventories. Thank you.
Thank you. Our next question comes from Jerry Liu from UBS. Please ask your question.
Hi. Good evening. Thank you. I would like to just ask a couple of things on gaming, maybe separating domestic and international. First on domestic with the BanHao restarting, I’m wondering if we can be a little bit more positive on growth, on either grossing or revenue growth later this year, or should we have a little bit more patience given some of the titles might be coming later? And then on the international side, first of all I was wondering if we did have that accounting adjustment that was discussed last quarter if we had that in the first quarter at all? And then secondarily, can we see the international — or will the normalization from COVID take a bit longer to play out? Thank you.
Thank you for the game questions. On the international games then yes, we had a sort of catch-up of revenue in Q4 related to one of our subsidiaries Supercell. And then there was a accounting catch revenue in Q1 related to Riot. The catch down was smaller in magnitude than the catch up. In terms of the outlook then, we don’t have a crystal ball. But generally speaking, the game business outside China, particularly for popular mobile games had a very buoyant period from late 2020 through late 2021. And now, it’s facing a tough comparison against that period. And when I say it, I mean the industry as a whole. And there’s a number of listed companies with big mobile games that have reported a similar phenomenon. So I think it’s reasonable to expect that PUBG Mobile there’ll be tough comparatives for another few months before the year-on-year trends normalize towards the end of this year.
Separate from PUBG Mobile then most of our big PC games are doing fine that they weren’t as — they didn’t benefit from COVID as much necessarily and they aren’t hurt by a COVID hangover. And then, we have very kind of long life mobile games like Clash of Clans which are also doing fine. The rest is around a little bit quarter-on-quarter depending on the content release in a given quarter. But the user trends and the propensity to pay appear to be stable to growing over time. So that’s — and then as we look into 2023 and beyond, that’s when we expect more sort of big budget games that we’ve been ramping up in the last two years to be released and to start meaningfully impacting the international game revenue positively.
On the Domestic Game business then I think that as Martin suggested, the BanHao approval is positive for a number of reasons. One being that more games can be published. Another being the signaling effect in that it appears that the regulators are now much happier with where the industry is and therefore, it’s a more stable environment where people need to sort of look over their shoulder and try to second guess whether there’s other regulatory changes looming on the horizon. So overall, we’re very happy with the BanHao approvals. We ourselves didn’t get a game on that approval list, this time which is fine. The period with no BanHao approvals obviously hurts most those companies, which don’t have any games and therefore don’t have any cash flow versus the bigger more established companies that already have games already enjoy cash flow, and could ride out that period more comfortably. So we think that, it was sort of very rational that the BanHao starts with the smaller game companies and then will move up to the bigger game companies, including ourselves in the future.
I think in terms of the outlook then yes with more BanHao being issued, and with the industry now on a more stable regulatory footing then it’s reasonable to expect that, the industry grossing trends will begin to improve as we move through the year. And over time that will then translate into reported revenue trends, but it’s not an immediate process and it will take several months to play out.
Thank you. Our next question comes from John Choi from Daiwa. Please ask your question.
I have two questions. So first of all, I think Weixin video accounts, has continued to gain good traction. Can management elaborate a bit more about the potential of this advertising business in the longer run? I know that, we are still focusing on user engagement and carefully trying to grow the business. But eventually, would it be fair for us to see a similar advertising business ad loads or business potentials such as our peers in this area? That’s my first question.
My second question is, we noticed that, the investees the value has come up a lot this quarter given the market volatility. Has this made us to rethink of our investment strategy going forward? And what would be our key focus? I think management did mention previously, there will be more of a balanced approach. But I was – if we – if this might be more opportunity for us to play aggressive offense or a bit more conservative going forward? Thank you.
So I will take the first question. In terms of Video Accounts, it is true that, we’re very encouraged by the strong growth momentum of Video Accounts in terms of video viewed as well as time spent. And I think if you want to think about the monetization potential, I would say, eventually right, it should have a similar monetization per time spent, with similar products in the market. But it will take time to get there. And along the way, we’ll continue to improve the user experience, so that we try to strike a better balance between monetization and user experience.
So a case in point is, like our moments advertising. We would be probably releasing inventories into the market on a more gradual basis than the industry peers. And along the way, we’ll continue to make improvements. And our ad load may or may not be the same. Most likely, I would say, our ad load probably will not be the same. It would probably be more self restrained in terms of the ad load. But we felt we can actually achieve potentially a higher CPM eventually, by continuously improving the technology by leveraging the fact, that both the user base, as well as the contents, are actually high end in nature and leveraging the fact that, there’s better connection with the overall Weixin ecosystem, including official accounts, and the social graph, as well as the social communication infrastructure, and the connection to Mini Programs, so that their conversion can actually increase.
And the fact that, I would say, when you have a shorter total amount of time spent on the platform versus a longer time, the more of a diminishing margin return actually starts coming. So the first 20 minutes is probably going to be worth more than the last 20 minutes. So that’s sort of the overall way for which you would think about this. And over time, I was trying to strike a better balance between monetization and user experience, but also try to unleash the full potential of the monetization of this platform.
And on your second question around, our portfolio of investments, in other listed companies, and the reduction in the value thereof quarter-on-quarter, then as a first point, if you look at the reduction in value actually a very big percentage of that reduction was due to the proactive steps we took that I think are very good for investors, meaning we distributed the stake in JD worth about US$16 billion directly to investors. We disposed of US$3 billion stake in another company and the proceeds of that then partially being used for buybacks of our own stock. And we also disposed of a couple of billion dollars of stakes in other companies.
So all-in during the first quarter, if you compare the capital, we sort of raised from divestments and distributions, it was about four times bigger than the capital we put to work investing in other companies. When we do those divestments and distributions then it’s inevitable and natural and desirable that the value of our portfolio that remains is diminished by the divestments and distributions.
Looking forward, we continue to be active in divestments, and we’re very recognized in to the multiple macro risks out there, particularly the fact that central banks — world are generally increasing interest rates at very rapid rates and this is something that hasn’t been seen for decades. And it has implications for how investors value some of the high growth, low margin, high duration tech companies, which represent a portion of our portfolio.
So we are very thoughtful about those risks and managing those risks. And one of the ways that we do manage those risks is through the step-up in the pace of divestments, distributions and so forth.
But that said, we also are a company that generates very substantial free cash flow. We’re a company by virtue our position we have insight into emerging technology trends among consumers, among enterprises. And we see new opportunities, interesting opportunities emerging, or sometimes we see old opportunities, which we’re familiar with from previous — reemerging as valuations decline. So we’re being very selective. We’re being very disciplined both in terms of investing carefully and also divesting where necessary, but we continue to find opportunities and we continue to put capital to work against those opportunities.
Great. Thank you. Our next question comes from Gary Yu, Morgan Stanley. Your line is open. Please ask your question.
Hi. Good evening. Thank you for the opportunity to ask question. I actually have two follow-up questions to the prior questions. First one is on advertising margin. I understand that there are multiple factors affecting the margin. Could management help us to kind of quantify or rank different factors in terms of level of impact be it lower eCPM from our mobile [ph] inventory? And also some of the COVID impact, some of it is video account investment, so how should we look at kind of margin trend going forward based on these various impact?
The second question is regarding the comment on cost optimization. Is there any room for more aggressive control in terms of headcount related G&A or R&D expenses? I understand that there’s a slight increase — still in first quarter. Is there any further room for more optimization either from non-core business or any other areas where we can see more aggressive cost cutting from this area? Thank you.
Yes. So on the advertising margins, I think, that last quarter we tried to prioritize or rank, force rank the various factors that were affecting advertising business. The top factor was really regulations impacting demand, regulations impacting categories, such as education and games and reducing that demand for advertising. A lesser factor was regulations impacting supply, such as the flash screen ads. And those have some negative impact on our ad network business, but less so on moments or official accounts where the challenge was more of a demand problem.
Refreshing that framework this quarter then the paramount driver is COVID. The COVID situation is tragic and it has negative consequences for advertising spend for the multiple the three different reasons that I talked about earlier. And for us – and while the current COVID being brought under control then they’re very – it’s a great challenge for the advertising industry.
Again, the good news is that, while it’s taken a period of time for the COVID to be brought under control in Shanghai, it was brought under control very quickly in Shenzhen. So there is a precedent in the very recent past for successfully bringing COVID – the less good news for our advertising business is that Shanghai is the sort of capital if you will for media, advertising, marketing decisions in China, particularly for multinational companies and Shenzhen is not. And so with the situation in Shanghai, it has a disproportionate impact on advertising nationwide. Thank you.
In terms of cost control – second question. In terms of cost control I think for cost items in relation to the organization and staff, our principle is that the optimization is done based on structural changes and structural needs. So we’re not likely going to react to temporary factors, which will go away in the short to medium term.
So if we look at the current situation, the incremental negative impact is actually largely related to COVID. So that’s why we felt we’re not going to react to this by optimizing our organization and staff further. But we may pursue other cost controls reduction in marketing costs. If there’s further lockdown then there’s probably not that much we need to do as much marketing for example. So that will be the routes that we’ll be looking at. But I think organization and staff is going to be much more based on structural factors.
Our next question comes from Elinor Leung from CLSA. Please ask your question.
Hey, thank you very much management for opportunity to ask questions. The first question is regarding the resumption of the game approval. Given in the first month there’s only five – 45 new game is approved, do you think there is a structural change in the market that the government is going to approve less game than before the suspension? If that’s the case, how is that going to affect our future game growth if we get less new game in the future? And the second question is regarding the mobile app network. We see a sharp decline in the quarter because of the regulatory change. And what do you think the future of this mobile app network in the future? Thank you.
I think on mobile ad network, it’s an industry that is prevalent globally. It’s an industry that’s sort of necessary for the – smaller and medium-sized apps and websites. And so it’s an industry that’s here to stay in China. It’s been through many previous shocks. But we haven’t talked about it as much in the past because during the PC Internet era, Tencent was really a laggard or not present in the PC ad network. And it was only with the boom in mobile Internet that we became a substantial participant in mobile ad network.
So this cycle the two big participants in mobile ad network, us and ByteDance are different from the big participants in prior cycles. But ad network has rebounded from prior cycles. And I’m sure it will rebound from this cycle because on the supply side there’s enormous amount of inventory sitting in these small- and medium-sized apps that needs to be monetized for the apps to survive. And on the demand side, there’s always advertisers who are looking for incremental traffic even if it’s from less branded media sites.
On the game BanHao then the answer is yes. We believe that generally speaking there will be fewer game approvals in the future than they were in the pre-2018 period. And we have held that belief now for a couple of years. And it’s a big part of the reason why in the last two years, we’ve reconfigured our game business from top to bottom to focus on releasing and usually developing fewer bigger budget and hopefully better games. And we think that we have been — we are really a pioneer in the industry in terms of doing that.
At any point in time, we generally have a similar or smaller pipeline than competitors who have much fewer headcount. And the reason is because we’re putting more headcount against each game and the belief that only a limited number of games will secure the BanHao in the future. And therefore we want to make that limited number of games to be all that they can be.
And I think that while we’re very early in this the results so far are quite positive. If you look at 2021 then two of the games that we released were the two most successful games in the industry by — measured by users. And this year the Return to Empire game is now the number two in strategy genre. That’s a small user, but high ARPU genre. And then more importantly looking forward, we’re pretty excited about the quality of the content that we have in our pipeline.
And again it’s a narrower pipeline with fewer, but we think bigger better titles in the case three years ago because of this change in the regulatory environment as well as the change in user taste even without the regulatory change. Users are becoming more sophisticated more informed about the quality of games and therefore it makes sense to focus more resources on fewer bigger bets.
Operator, let’s take the one last question.
Thank you. Our last question comes from the line of Alex Yao from JPMorgan. Please proceed.
Thank you management for taking my question. A couple of follow-up questions. Number one on cloud. In this quarter we have seen the revenue impact on cloud given the strategy of the transition. Can you share with us the margin trends seems to transition? So that’s the first one.
Second one is on the video — the long form video business. I understand you guys are sharply focusing on cost optimization and the margin improvement this year. Does this also apply to the video business? Is it improving margin achieving breakeven one of your key priority in this line of business? Thank you.
In terms of the impact on the cloud in respect of the gross margin, it actually improved a bit because of the fact that we have mentioned getting away from loss suffering contracts. So it did help us in this quarter.
In terms of your question about Tencent Video — then people use the word healthy a great deal probably too much in connection with China Internet. But we — our aspiration is not to get our video business to a temporary breakeven situation. It is to over time move our video business to a structurally healthy and sustainable position. And in reality there have been quarters in the past when Tencent Video has already achieved breakeven, but we didn’t sustain that. And what’s critical is really sustaining it.
Achieving one quarter breakeven is not difficult in the video industry — not to commission expensive content. You can choose even though you’ve already commissioned expensive content not to air the content in that quarter because then the reported P&L that quarter is flattened. You can choose in the current quarter to write-off capitalized video content so you have a big loss this quarter and then the next quarter you add that content it still picks up some traffic and revenue. So the incremental margin optically is very high even though the true economic return is not attractive.
And those are things that one can do if one wants to be breakeven next quarter. But that’s not what we’re aspiring to achieve. We’re aspiring to just move the business to a structurally healthy position. And I think we’ve already done what I hope is the most challenging part which is that Tencent Video was the eighth or ninth company to enter the space in China. It’s now the clear leader in terms of subscribers, in terms of subscription revenue, in terms of advertising revenue.
As I mentioned it has already achieved in some past quarters. And now we want to move towards a sustainably profitable position. And part of that is continuing to optimize the revenue, through price rationalization and so forth. Another part of it is, being continually selective about the content that we air. And when we were moving from ninth place, to seventh place, to fifth place, we had to compete in every kind of content because we didn’t know, which — really mattered. Now, that we’re in the first place, we have much greater clarity on what content counts, what content doesn’t. And so we can be more selective about allocating, our spending for the content that counts.
And then finally, and somewhat differentiated, we also have the opportunity that we’re seizing to benefit from in the vertical integration with upstream IP over, which we already have influence whether that’s because the upstream IP, is a web novel within China Literature or its content produced by new classic media or it’s a mobile game from the Tencent game portfolio.
So the long-form video industry in China has been an extremely challenging industry for many years. And now, it’s as difficult as it’s ever been. But the industry has also now moved toward a much more rational stance in – costs, in terms of ARPU. And we are seeking to continue that shift and ultimately make this a good return business, just as long form video elsewhere in the world is a good return business. Thank you.
Thanks, James. Thank you everyone for joining the call today. We are closing the call now. If you wish to check out our press release and other financial information, please visit the IR section of our company website at www.tencent.com. The replay of this webcast will also be available soon. Thank you and see you next quarter.
Thank you. That does conclude our conference for today. Thank you for participating. You may all disconnect.