Tencent: The increased R&D investment is mainly used for AI (3Q24 conference call summary)

The following is the summary of the Q3 2024 earnings conference call for $TENCENT(00700.HK) . For the financial report interpretation, please refer to Tencent: Accelerating Investment, Slowing Profit, Can the King of Stocks Maintain Both Offense and Defense? .

1. Core Financial Report Information Review:

2. Detailed Content of the Financial Report Conference Call

2.1 Key Information from Executives:

2.1.1 Business Progress

1. Value-Added Services (VAS)

a. Revenue: Reached RMB 83 billion, a year-on-year increase of 9%.

b. Accounted for 49% of total revenue, with social networks at 18%, domestic games at 22%, and international games at 9%.

c. Social Networks: Revenue of RMB 31 billion, a year-on-year increase of 4%, mainly driven by increased music subscriptions, game item sales, and mini-platform service fees.

d. Music Subscriptions: Subscriptions grew by 16% to 119 million, revenue grew by 20%, benefiting from optimized recommendation algorithms and improved sound quality.

e. Video Subscriptions: Subscriptions grew by 6% to 116 million, driven by animations and exclusive series.

f. Domestic Games: Revenue of RMB 37 billion, a year-on-year increase of 14%, with core growth coming from the comprehensive contributions of "Honor of Kings," "Game for Peace," "DNF Mobile," and "Valorant."

- "Honor of Kings" and "Game for Peace" achieved healthy gross revenue growth supported by promotional activities.

- "DNF Mobile": The second-ranked mobile game, plans to launch content updates during the Spring Festival to increase user engagement.

- "Delta Action": The first first-person action game to be released simultaneously on mobile and PC, expected to enter the international market in the coming months.

g. International Games: Revenue of RMB 15 billion, a year-on-year increase of 9%, mainly driven by the strong performance of "PUBG Mobile" and "Brawl Stars."

- "PUBG Mobile" achieved record high gross revenue, and "Valorant" saw gross revenue increase by over 30% year-on-year.

2) Social Networks and Communication Services

a. The monthly active users (MAU) of WeChat and QQ continue to grow, with WeChat's MAU reaching 1.38 billion and QQ's mobile MAU recovering to 562 million.

b. WeChat Mini Programs: Total transaction volume (GMV) reached RMB 2 trillion, expanding to scenarios such as dining, electric vehicle charging, and healthcare.

c. WeChat Mini Shop: Provides merchants with a standardized e-commerce platform experience, lowering the entry barrier for merchants through WeChat social interaction and payment functions, with user interface upgrades supporting order tracking and quick returns.

3) Marketing Services

a. Revenue: Increased by 17% year-on-year, accounting for 18% of total revenue.

b. Video Account Advertising: Revenue increased by over 60% year-on-year, enhancing advertisers' exposure and conversion rates.

c. Mini Program Advertising: Mini dramas and mini-games provide high-value video advertising inventory, promoting closed-loop demand.

d. WeChat Search: Application of large language models enhances the relevance of search results, significantly increasing commercial query volume and click-through rates.

4) FinTech and Business Services

a. Revenue: Reached RMB 53 billion, increased by 2% year-on-year, accounting for 32% of total revenue.

b. FinTech: Slight decline in payment revenue, growth in wealth management service revenue, and an increase in commercial payment transaction volume.

c. Business Services: Growth in cloud service revenue, with e-commerce transaction volume driving an increase in technical service fees.

d. AI Cloud Revenue: GPU-related revenue rapidly increased, accounting for a double-digit percentage of infrastructure service revenue.

e. Innovative Technology: Launched the "Tencent Hunyuan Turbo" model, improving training efficiency and reducing inference costs.

2.1.2 Financial Performance

1) Overall Financial Performance

a. Total Revenue: RMB 167.2 billion, increased by 8% year-on-year.

b. Gross Profit: RMB 88.8 billion, increased by 16% year-on-year; overall gross margin was 53%, an increase of 4 percentage points year-on-year.

c. Operating Profit: RMB 53.3 billion, increased by 20% year-on-year.

d. Non-IFRS Operating Profit: RMB 61.3 billion, increased by 19% year-on-year.

e. Net Profit Attributable to Shareholders: Non-IFRS net profit was RMB 59.8 billion, increased by 33% year-on-year.

f. Earnings Per Share (Diluted): RMB 6.34, increased by 36% year-on-year, mainly due to a reduction in share capital from stock buybacks.

2）Performance of Gross Margin by Business Segment

a. Value-Added Services (VAS): Gross margin of 57%, up 2 percentage points year-on-year, mainly influenced by improved gross margins in high-profit games, music, and long video businesses.

b. Marketing Services: Gross margin of 53%, up 1 percentage point year-on-year, mainly driven by revenue growth from Video Accounts and WeChat Search.

c. FinTech and Business Services: Gross margin rose to 48%, up 7 percentage points year-on-year, driven by improved cost efficiency in cloud business, growth in wealth management, and enterprise service revenue

3) Expense Situation

a. Sales and Marketing Expenses: RMB 9.4 billion, up 19% year-on-year, accounting for 6% of revenue (5% in the same period last year), with the increase attributed to supporting the promotion of new games domestically and internationally.

b. R&D Expenses: RMB 17.9 billion, up 9% year-on-year, mainly invested in strategic areas such as artificial intelligence.

c. Administrative and General Expenses: RMB 11.2 billion, up 14% year-on-year, influenced by increased performance bonuses for some overseas subsidiaries.

d. Number of Employees: Approximately 109,000 as of the end of the third quarter, up 3% year-on-year, an increase of 3% from the previous quarter, mainly due to the annual campus recruitment season.

4) Capital Expenditures and Cash Flow

a. Capital Expenditures: Operating capital expenditures of RMB 14.7 billion, up 122% year-on-year, mainly invested in GPU servers; non-operating capital expenditures of RMB 2.4 billion, up 74% year-on-year.

b. Free Cash Flow: RMB 58.5 billion, up 14% year-on-year, mainly benefiting from strong revenue in the gaming business, up 45% quarter-on-quarter.

c. Net Cash Position: RMB 95.5 billion, up 33% quarter-on-quarter, driven by the generation of free cash flow, although partially offset by cash used for share buybacks.

2.2 Q&A Analyst Questions

Q: Can management share insights on the industry impact of this year's popular games (such as "Dungeon & Fighter Mobile," "Endless Winter," and the invested "Black Myth: Wukong")? What do these success stories imply for future gaming strategies?

A: Regarding the gaming business, we have seen significant success for some games developed in China in the global market over the past few months, such as "Black Myth: Wukong," "Endless Winter," and "PUBG Mobile." This trend is attributed to the rapid acceptance of new models like virtual goods and mobile platforms in the Chinese market. Additionally, China has a large engineering team that supports game development and operations, actively applying new technologies like Unreal Engine 5.

From Tencent's strategic perspective, the scarce resource in both international and domestic markets is "evergreen" games. The difficulty of launching new games that become hits has increased, and once a game becomes popular, the opportunity to continuously invest in transforming it into an evergreen game is also more attractive. Tencent's strategy is to leverage the strengths of different studios. Tencent's internal studios have advantages in player-versus-player games and continue to strengthen this area; while external studios like the development teams of "Black Myth: Wukong" and "Endless Winter" excel in narrative-driven or strategy games. Tencent deepens its relationships with these studios through investment and publishing collaborations, leveraging their specialties. This strategy combines Tencent's internal studios and external partnerships, allowing each studio to focus on its areas of expertise.

Q: Regarding the e-commerce business, we noticed that WeChat Mini Stores have been upgraded to enhance e-commerce services. Can management introduce the positioning and changes of this upgrade? How should we view the potential of this business? Can it be understood that its market positioning is not limited to live-streaming e-commerce, but covers a broader e-commerce market?**

A: Regarding WeChat Mini Stores, our goal is to create a unified and trustworthy e-commerce platform within WeChat, providing standardized products and verified merchants. The products in the Mini Stores will become the foundational data structure within the WeChat ecosystem, displaying product information, while merchants must undergo verification and accept quality monitoring. This upgrade will provide consumers with higher quality assurance and a better shopping experience, such as order tracking and quick returns. For merchants, they will receive more comprehensive transaction support, especially the ability to access new traffic and customers.

The advantage of WeChat Mini Stores lies in the fact that the shopping experience is fully integrated into the WeChat ecosystem, allowing access to social traffic from chats, group chats, Moments, as well as media traffic from official accounts, mini-programs, video accounts, and recommendation engines. Once we understand the source of the products and the selling merchants, we can more confidently provide traffic support to users, creating an attractive growth flywheel effect for merchants.

We are excited about the potential of the WeChat e-commerce ecosystem for long-term development. Referring to the mini-program ecosystem, many transactions have already been conducted through mini-programs, but many of them are service-oriented rather than physical goods. Even in the physical goods sector, merchants have achieved considerable transaction volumes, although they primarily target known customer groups. In the past, merchants guided users to use WeChat Pay through offline stores, thereby activating mini-programs, but during this process, we found it difficult to understand transaction details, and merchants struggled to acquire new customer resources. WeChat Mini Stores can change this by allowing merchants to reach a wider range of social and media traffic, thus going beyond a purely mini-program infrastructure.

A similar example is the introduction of video accounts. Before video accounts, there were already a large number of non-standardized short videos within WeChat, and video accounts achieved significant growth by providing standardized product formats and traffic support. Similarly, WeChat Mini Stores provide a standardized and trustworthy trading environment, which will significantly enhance transaction volume.

Q: Regarding WeChat search, you mentioned that commercial queries and click-through rates have increased year-on-year. Can management clarify which industries' advertisers are more frequently using commercial keywords to drive traffic? Besides the search function within WeChat, what other entry points can advertisers use to leverage search queries? Additionally, will the generative AI "Yuanbao" be embedded in commercial sponsored responses in the future?

A: Regarding WeChat search, the large advertisers currently purchasing search keywords include the financial services, internet services, gaming, automotive, and local services industries, with recent additions from luxury goods advertisers. In addition to WeChat's "Search" function, there are indeed multiple entry points to utilize search queries, such as video accounts and mini-programs. Some entry points take the form of search boxes, while others are triggered by user behavior. For example, the SKU standardization feature provided by WeChat Mini Stores means that future user interactions can trigger a series of related product information cards to be displayed, thus responding more effectively to user needs and leveraging search technology to drive these displays.

Regarding Yuanbao, it is currently not embedded in commercial search results. Our current focus is on enhancing Yuanbao's appeal to users rather than premature commercialization. Q: Regarding international games. You mentioned extending the deferred revenue period; is this only for certain flagship games? Please remind us of the scope of the deferred period for international games. Additionally, based on the better revenue growth you mentioned, can international game revenue achieve more stable and sustainable growth next year or in the coming years?

A: For international games, the deferred revenue mainly applies to certain flagship games. The previously disclosed deferred period for domestic games is usually 6 to 9 months, while the deferred period for international games is similar or longer, and in some cases, significantly longer. We remain optimistic about the revenue prospects for international games, mainly based on the business trends of existing games, the accumulated deferred revenue over the past few quarters, and the potential increments brought by new game releases.

Q: First, from a macro perspective, in the face of domestic policies leaning towards growth promotion since September and a more complex international geopolitical environment, how does the company adjust its business and strategy to seize domestic policy opportunities while responding to changes in the international environment?

A: We are encouraged by the recent economic stimulus policies introduced by the Chinese government, believing that the direction of these policies is highly constructive and timely, demonstrating the government's firm determination to promote economic recovery. Therefore, we hold an optimistic view on the long-term economic outlook. Although the implementation and effectiveness of the policies will take some time, we believe that economic growth will ultimately accelerate again.

In light of this situation, we will continue to focus on the right approach. Over the past few years, we have experienced a cycle of domestic regulatory scrutiny, and this principle will extend globally in the future. We are always committed to complying with rules and regulations worldwide, not only in a literal sense but also actively understanding and implementing regulatory intentions. This proactive compliance attitude allows us to adjust our products and communication methods in advance to meet various compliance requirements.

At the same time, we will continue to optimize products and create user value, focusing on meaningful products and services for users, customers, and partners, rather than dispersing our energy across too many areas. Additionally, in terms of internal management, we maintain a culture of excellence and emphasize cost efficiency, practicing strict self-discipline to avoid unnecessary expenditures and distractions. These measures will not only help us maintain sustainable business development amid fluctuations in the macroeconomic environment or changes in the regulatory landscape but also lay a solid foundation for future growth.

Q: Regarding the consumer end, can you further elaborate on the latest trends in market services and payment indicators? In particular, during the recent Double Eleven event, the average order amount for payments decreased. Do you think there might be a turning point in transaction volume regarding consumption trends?

A: From the current macroeconomic environment, since the policy announcement, transaction volume in October has increased, while the year-on-year growth rate for the third quarter has slowed month by month. This trend indicates that the policies are beginning to take effect. We expect that economic recovery will still take time, but in the long run, we hold a positive attitude towards economic rebound. This optimism is based on several favorable structural factors, including the high dedication of Chinese workers, a strong reserve of engineering and technical talent, the entrepreneurial spirit of various enterprises, and a comprehensive supply chain system. Therefore, we are optimistic about the recovery of the long-term macroeconomic environment

Q: Regarding the WeChat e-commerce business, how has the management clarified the short-term planning for WeChat Mini Stores? Can you share the specific steps, key areas, and strategies for scaling the business in the next few quarters, especially in the context of slowing growth in the short video and live-streaming e-commerce markets and intense competition in traditional e-commerce? How will WeChat e-commerce expand its scale and increase market share in such an environment?

A: The short-term goal for WeChat Mini Stores mainly focuses on continuously optimizing the infrastructure, specifically building a standardized, indexable, and quality-assured trading environment. We need to enhance functionalities in areas such as infrastructure, customer service, consumer experience, and merchant tools. Once these products and features are perfected, we will strengthen our linkage with various traffic sources, including social and media channels. Overall, the short-term focus is more on improving products and functionalities rather than immediate short-term performance targets, with the expectation that business growth will naturally follow once the infrastructure is complete.

Q: Regarding the recent open cooperation with Taobao. Can the management share the progress and benefits of this collaboration? What potential cooperation opportunities might arise in the future?

A: Although the cooperation with Taobao is still in its early stages, we observed good usage of WeChat Pay on the Taobao platform in October, which is beneficial for both parties. For WeChat Pay, it has increased the total payment volume (TPV) and enhanced revenue; for Taobao, most new users using WeChat Pay are first-time customers on Taobao, which adds significant value. We are satisfied with the initial results of the collaboration and believe that as WeChat Pay becomes more convenient on Taobao, it will attract Taobao to invest more in advertising on the WeChat platform.

Q: Regarding the newly launched game "Delta Operation." Despite high user engagement and retention rates, the monetization performance of this game seems somewhat lagging. Is this situation due to the timing of the monetization strategy or design issues?

A: Regarding "Delta Operation," this game is a PVP multiplayer game, and according to past practices, we prioritize enhancing user engagement and user numbers in the early stages of the game's launch, gradually rolling out monetization. In terms of "Delta Operation's" performance, the monetization progress is good, even better than some of our previous large PVP multiplayer games. The reason you may not see this in the relevant data is that "Delta Operation" is our first large game launched simultaneously on mobile and PC. Although most users are concentrated on mobile, a significant portion of the revenue actually comes from the PC side. However, we can assure you that "Delta Operation" performs exceptionally well in terms of user engagement and monetization.

Q: Despite the low single-digit growth in China's retail industry in the third quarter, Tencent's payment revenue has declined year-on-year. Is Tencent Pay overly reliant on certain weaker consumption categories?

A: Regarding the comparison of payment revenue with China's retail consumption, we still have confidence in the performance of our payment business. The reasons for the revenue discrepancy are twofold: first, we have gradually reduced some low-quality and even loss-making transaction volumes this year, which has had some impact on the overall payment volume. Second, our payment business primarily covers small daily consumer goods rather than all retail consumption. ** Therefore, we are more focused on the number of transactions rather than the transaction amount or revenue. Based on the data regarding transaction volume, there is an approximate year-on-year growth of 10%, which leads us to believe that the payment business remains strong.

Q: Over the past two years, Tencent has achieved significant margin expansion. So in the medium term, does Tencent have a more normalized profit growth rate target? Or is there a target ratio aimed at balancing revenue and profit?

A: We do not have a specific profit growth target that can be publicly disclosed, but the overall direction is we hope to achieve revenue growth in a relatively challenging macroeconomic environment, which we have already accomplished and hope to maintain. Some of the drivers of our revenue growth are of high quality, so we hope to leverage revenue growth to drive gross profit growth, and then translate that gross profit into operating profit to create operational leverage. This is the model we pursue, but given the dynamic nature of the business environment, each factor may fluctuate from quarter to quarter, but the overall direction remains unchanged.

Q: Regarding the update on the repurchase budget for 2025, can it be assumed that Tencent's repurchase amount will at least reach the amount repurchased in 2024? What is the method of shareholder return?

A: Regarding the repurchase plan for 2025, we will announce specific arrangements in the year-end financial report, and we cannot disclose more information at this time. The repurchase target for 2024 is RMB 100 billion, and we have already completed over RMB 90 billion, and we believe it will exceed the set target. Looking ahead to next year, our core consideration is to share value with shareholders. The company has ample operating cash flow and holds a large investment portfolio, which can sustain itself and even provide additional returns when needed. In terms of capital expenditure, we have an aggressive yet moderate plan, especially in cloud business and AI development, which is relatively more cautious compared to many American companies. Therefore, we expect to generate significant free cash flow next year, which can be used for dividends and stock repurchases.

Q: GPU-driven services account for several percentage points of the Infrastructure as a Service (IaaS) business. What is the expected contribution of AI-related revenue in enterprise services in the future?

A: Regarding the specific monetization of AI, it is currently mainly focused on content recommendation and advertising placement. The AI engine has increased user engagement time in these two scenarios and significantly improved the effectiveness and response rate of advertising, directly benefiting both business and advertising revenue. This effect is particularly pronounced for video accounts and performance advertising, where the scale is large.

Regarding Infrastructure as a Service (IaaS) revenue, the current proportion of AI has reached double digits. However, compared to American cloud computing companies, AI revenue in the Chinese market is still relatively limited, mainly due to:

Chinese enterprises have not yet adopted AI on a large scale; the U.S. has a large SaaS ecosystem, with many companies enhancing customer charges by adding AI features, while the Chinese SaaS ecosystem is not yet active enough; additionally, there are relatively few AI startups in China, and the demand for computing is low. Therefore, although there has been growth in cloud AI business, it will not expand as rapidly as in the U.S. market in the short term

Q: Can you explain in more detail the strategy of how the management utilizes AI models for monetization across different business lines, and how we can see the actual effects?

A: Regarding the promotion and application of AI in different products and services, AI is currently widely used as a productivity tool. For example, the "collaborative assistant" commonly used by engineers has significantly improved business efficiency. Each product line is also testing and integrating AI technology, whether to enhance efficiency in production processes or to optimize user experience. It is expected that in the coming quarters, as actual use cases gradually expand to a certain scale, we will provide further updates.

Q: Recently, we have seen strong growth momentum in shooting games in Southeast Asia, China, and even globally, with "Peacekeeper Elite" performing well. From the perspective of player preferences, have we observed a trend of players leaning towards shooting games? In the domestic market, given the large market size, can we expect more segmentation in our game portfolio?

A: Regarding first-person shooter games, we have indeed observed that young users in China (especially those aged 18 to 25) increasingly prefer first-person action games, such as "Valorant" and "Delta Force." This trend has structural characteristics. In the Western gaming market, first-person action games are the dominant genre, and among young players in China, this genre is also gradually taking the lead. We expect that over time, it will become the main genre in the entire Chinese market, which is favorable for us, as Tencent performs well in this genre. Additionally, newly launched first-person action games will not significantly erode the market of existing games, as there is considerable differentiation within the genre, such as kill times, hero types and professions, tactical versus chaotic gameplay, and realistic versus cartoon styles.

Q: Regarding the fintech business, wealth management has shown positive growth. What are the strategies for wealth management and lending? Given that other fintech companies have mentioned macro challenges in credit business, can we expect to focus more on wealth management in the future? Regarding the invested enterprises, do we have further plans to unlock the value of invested enterprises, or is the fintech business already strong enough to deliver shareholder returns?

A: Regarding wealth management and credit business, the recent growth in wealth management has been primarily driven by money market funds, exhibiting certain counter-cyclical characteristics. Furthermore, we hope to gradually transition users from money funds to long-term equity funds and ETFs, and we are developing related products and establishing conversion mechanisms. For the credit business, due to the impact of the macroeconomic environment, we have been more cautious recently, maintaining a conservative credit risk control strategy. When economic conditions improve, we may appropriately increase credit issuance.

Regarding asset divestment, we continue to actively manage our investment portfolio, especially in the past few months during the market rebound, we have increased our selling efforts. The purpose of asset disposal is capital redistribution for new investments, stock buybacks, or retaining more funds for future operations. This year, our net cash holdings have increased, despite significant buybacks and dividends

Q: It is understood that IEG has made internal adjustments. Can the management share more details and reasons regarding these adjustments? How are these adjustments related to the overall trends in the gaming market and Tencent's current business situation?

A: The adjustments you mentioned do exist, but they have actually been completed a long time ago. For example, the adjustments to the "Honor of Kings" team occurred at the end of last year, while the adjustments to the "Peacekeeper Elite" team were completed at the beginning of this year. These adjustments have been mentioned multiple times in our earnings call. In fact, these adjustments have been very effective, as both "Honor of Kings" and especially "Peacekeeper Elite" have achieved significant growth this year.

The logic behind these adjustments is based on our overall strategy for "evergreen" games. We believe that a game has the potential to become an "evergreen" title once it reaches a certain scale, especially games with a large user base. The key is not the game itself, but the development team, creativity, and the philosophy of operation and community management behind it. When we find that a team's creativity is exhausted or operational effectiveness is poor, we make adjustments to restore innovation, activity, and creativity, bringing the game back on a growth track.

In the future, we will continue to focus on maintaining and expanding "evergreen" games while launching new titles with "evergreen" potential. To this end, we will focus more on high-quality games with strong positioning and large production standards to exceed player expectations and maintain a leading position in the market. "Delta Force" is a great example of this focused strategy, and we will launch more works with "evergreen" potential in the future.

Q: Tencent's advertising business has performed better than industry peers this year, and the video account has become one of the important drivers of the advertising business. How do you view the future prospects of your company's advertising business? The two main short video competitors of the video account derive a large part of their advertising revenue from e-commerce brands and merchants. Can it be said that the e-commerce industry will also be an important factor in fully unleashing the advertising potential of the video account?

A: Regarding the advertising business, the main driving factors for 2025 include the overall macro environment, which will be influenced by consumer confidence and consumption behavior, potentially accelerating, slowing down, or having a neutral effect on the advertising market. In terms of Tencent's relative performance, the key lies in the advancement of advertising technology, especially using GPUs and neural networks to enhance click-through rates, thereby directly driving revenue growth. At the same time, the further deployment of key resources such as video accounts and WeChat search is also very important. In the third quarter, the ad loading volume of video accounts increased, contributing to a year-on-year growth of over 60%, but its ad loading volume is still significantly lower than that of peers, remaining at a low single-digit level. In the future, we plan to gradually increase the ad loading volume, and we expect not to rely on the push of e-commerce closed-loop advertising in the short term.

When the ad loading volume reaches two-thirds of that of peers (i.e., about 10% loading rate, compared to the current 3-4%), the role of e-commerce advertising will become increasingly important. However, before achieving closed-loop e-commerce advertising, we can still rely on improvements in advertising technology, increased ad loading volume of video accounts, and growth in WeChat search to continue outperforming the overall advertising market

Q: What are the factors that facilitated the cooperation between WeChat and Taobao? Will there be more such collaborations, such as allowing external search engines to access WeChat content?

A: The most obvious advantage of the cooperation with Taobao is that it enhances user experience and provides us with more application scenarios for payment services, while helping Taobao acquire new users with a higher conversion rate. However, the realization of this cooperation requires a significant amount of design and agreement to ensure that user experience is not affected, such as preventing excessive advertising push from merchants. Additionally, in terms of compliance, ensuring that merchants undergo appropriate review processes for compliance management is also a key focus of the collaboration. In the past, due to the complexity of design execution, such collaborations were difficult to achieve. Now, with the improvement of cooperation and openness between platforms, such collaborations can be realized. In the future, Tencent will maintain an open mindset to explore more collaborations, but the premise is to ensure that user experience and the interests of content partners are fully protected.

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