Tencent:Crazy for "AI"! Love it ot hate it?

$TENCENT(00700.HK) released its Q4 2024 earnings after the Hong Kong stock market closed on March 19, Beijing time. This Tencent earnings report is indeed eye-catching, not only for Tencent shareholders but also for investors across the entire industrial chain of computing infrastructure and AIDC. The most focused questions revolve around how much capital expenditure budget is allocated for AI this year and how Tencent will leverage its social traffic advantage to promote its own AI Agent brand.

For Tencent shareholders, although AI provides Tencent with long-term upward imagination, the massive market value of USD 640 billion still relies on solid performance from traditional businesses for support.

At the same time, there is a mismatch in AI investment in the short term. The higher the investment in AI infrastructure this year, the more it will affect shareholder returns or external investment budgets, with profit pressure expected to be seen as early as the second half of the year. Especially under the backdrop of macroeconomic weakness and bottoming out, if the basic business can first emerge with its cyclical logic, it will greatly alleviate the above concerns.

So how did the actual performance in Q4 turn out? Let's look at the key points:

1. Nearly 100 billion Capex is a done deal: The most concerning number for the market—capital expenditure has unexpectedly started to roll out in the current period. Q4 capital expenditure was 39 billion, with this year's guidance raised from the initial total revenue of 5%-10% to 10%-15%, with Dolphin Research roughly estimating the scale to be between 80 billion to 100 billion.

This scale may be lower than the expectations of more aggressive industrial chain investors (100 billion to 120 billion), but for Tencent itself, it represents a maximum increase of over 40% compared to last year. This will directly impact subsequent profit margins (Q4 core business profit margin decreased by 2 percentage points quarter-on-quarter) and cash flow (Q4 free cash flow was only 4.5 billion), thereby squeezing the budget for shareholder returns.

At the end of Q4, Tencent had net cash of 76.8 billion, a decrease of nearly 20 billion quarter-on-quarter, mainly spent on Capex and buybacks.

2. Declining shareholder return rate: After the U.S. Department of Defense placed Tencent on the sanctions list, the company repurchased 1.5 billion HKD daily for five consecutive days, leading to speculation about the strength of this year's buyback.

However, the reality is that after the DeepSeek incident at the end of January, there was a significant shift in strategic direction—money needs to be heavily invested in AI. Therefore, compared to last year's total return of over 144 billion HKD from buybacks and dividends, this year's budget is only 80 billion for buybacks plus 41 billion for dividends, totaling 121 billion in returns, resulting in a return yield of less than 3% due to the increase in market value.

3. High R&D expenses may continue to impact short-term profits: Alongside the increase in Capex, R&D expenses also rose, with an 18% year-on-year growth, including a surge in server costs and significant increases in R&D personnel salaries. In the previous quarter's commentary, Dolphin Research had already indicated the arrival of a new investment Although Tencent has tried to control the other two expenses, with both sales and management expenses declining year-on-year, it still slightly missed expectations in the core operating profit that Dolphin Research focused on, with the profit margin dropping nearly 2 percentage points quarter-on-quarter, although it increased by 3 percentage points compared to last year.

However, the expectation gap lies in the R&D expenses, which were 4 billion more than the market expected. If we add that back, the core profit would be much higher than expected. Therefore, this upfront expenditure to seize an epic opportunity is not a major issue in the long run.

From the actions taken by Tencent since the fourth quarter to promote AI with almost the full strength of the group, as well as the planning of some potential projects in the gaming sector, we expect R&D expenses to continue this growth trend. Other expenses will also be controlled as much as possible, but they will still affect the original improvement pace of the profit margin.

4. Now let's look at the performance of the business itself, with many small surprises:

(1) Under high expectations, gaming still slightly exceeded expectations. In the fourth quarter, Tencent had few new games to contribute incrementally, with two mobile games performing mediocrely, and only "Delta Force," released in September, performing well, especially on PC.

The overperformance in the overseas market in the fourth quarter may have been driven by the deferred revenue from the third quarter, which the company mentioned last quarter. The revenue growth rate for value-added services has slowed down, and aside from the impacts of Tencent Video, music, and online literature experiencing slower or declining growth, most of it should still reflect some seasonal weakness in gaming during the fourth quarter, particularly due to the lack of new games, especially mobile games.

Looking ahead, the gaming sector is expected to face high base pressure from DnFM in the second half of this year, but there are still many promising games in the existing reserves. Several evergreen games showcased their strength during the Spring Festival, so it is possible that gaming can continue to achieve high growth.

(2) Advertising was not as bad as expected. Due to macroeconomic pressures in the fourth quarter and poor data from channel research, the market had conservative expectations for advertising revenue, mostly around 12%. However, the actual performance was a growth of 17%, and the gross profit margin increased by 1 percentage point year-on-year to 57.7%, a historical high. The high operating costs of video account advertising are no longer a drag but have become the second-largest contributor after Moments advertising.

The overperformance in advertising is a concrete reflection of Tencent's Alpha logic (social traffic is the cornerstone, with incremental sources compared to peers coming from video accounts, mini-programs, search ads, etc.). With policies tightening and the macro environment accelerating towards the bottom, more tailwinds are expected.

(3) The overall performance of the fintech and enterprise services business was in line with expectations, with a slight recovery quarter-on-quarter. Dolphin Research simply breaks it down: payment may still be under pressure, but the enterprise services (cloud business and video account commissions, etc.) show a more obvious acceleration in growth trends. In the future, driven by AI, the cloud business is expected to return to the pre-restructuring expansion pace at a faster speed and higher gross margin level.

Payment still depends on the effectiveness of macro policies, and in terms of market share, from the proportion of payment transactions, WeChat Pay at least maintains a steady upward trend in its share of mobile consumption payments. After Taobao Pay broke through, WeChat also has further potential to increase its penetration in the e-commerce sector.

5. Market capitalization rises, and South African brother are also reducing holdings.

In the fourth quarter, major shareholder Prosus is still quietly reducing its holdings. Taking advantage of the influx of southern funds and some foreign capital increasing their positions, Prosus has also increased the scale of its reduction according to its commitment plan (not exceeding 5% of the daily trading volume).

From the statistics of the last quarter from November 12 to yesterday, March 18, Prosus sold 60 million shares within four months, continuing to increase compared to the average monthly selling pace of the previous period. However, because Tencent's repurchase and cancellation efforts have always been greater than shareholder sell-offs (a net reduction of 100 million shares during the same period from November to March), as of the end of the fourth quarter, the major shareholder's holding ratio was 23.7%, slightly down 0.4% from the previous quarter.

6. Detailed financial report data overview

Dolphin Research's Viewpoint

The barrier of social traffic and an excellent and reliable management team are the cornerstones of investing in Tencent. It is believed that few funds will question Tencent's competitive advantages and Alpha returns. The most worth discussing is which expectations have already been factored into the valuation and which still have expectation gaps.

From the market's perspective, Tencent's recent "revaluation" is more based on the valuation multiples themselves, with not much adjustment in the fundamentals. Apart from the favorable conditions for games during the Spring Festival, it is difficult to quantify the performance of AI, so it is purely an emotional surge, pulling valuations hard from the previous quarter's 25-year Non-GAAP P/E of 14x to the current 19x. This can be referenced in conjunction with the expected profit growth rate (15%+) and historical valuation center (20x).

However, Dolphin Research also believes that the surprise in the fourth quarter's performance lies in the fact that Tencent's business growth elasticity still has some expectation gaps, and under the integration and reuse of internal ecological resources, effective control of expenditures (costs, sales, management expenses) outside of R&D expenses can offset some of the short-term profit impacts of AI investments.

In addition, how to balance input and output capabilities is something that Tencent's management can reassure investors. As long as the internal business vitality does not diminish, holding onto a gold mine will always yield gold, such as this year's small blue bag, AI search, and IMA, which are all manifestations of corporate innovation vitality.

Therefore, regarding the investment of 100 billion Capex into AI, different funds may have different thoughts. But for Dolphin Research, standing at the present, we are more inclined to face it with a relatively positive attitude and a medium to long-term perspective. After all, compared to the valuation of non-growth value stocks, the stock king with some growth potential is expected to soar higher.

**At the same time, we must also acknowledge that the significant increase in capital expenditures and R&D personnel will undoubtedly affect short-term shareholder returns and valuation cost-effectiveness. This year's shareholder return budget is HKD 121 billion, equivalent to USD 15.6 billion, and under the backdrop of a market capitalization of nearly USD 637.5 billion, the return yield is already less than 3%. Therefore, funds that valued Tencent's high shareholder returns and safe valuations over the past year may have a declining investment preference for Tencent, leading to short-term fluctuations in stock prices. Conversely, funds focusing on growth are also waiting for good entry opportunities**

The following is a detailed analysis

I. The WeChat ecosystem is the ballast of the business flywheel

In the fourth quarter, WeChat had 1.385 billion users, with a net increase of 3 million quarter-on-quarter, showing a slowdown in expansion. QQ is stagnant, losing nearly 40 million users in the fourth quarter after a decline during the peak season in the third quarter. Since integrating DeepSeek at the beginning of the year, WeChat's traffic and stickiness have significantly improved.

In addition to actively promoting AI search within WeChat, Tencent seems to have mobilized the entire group to promote AI applications in the past two months—Tencent Yuanbao. Whether within the Tencent ecosystem or on other external platforms, the promotion of Yuanbao is everywhere, directly leading to a surge in downloads in February.

Whether it's AI + WeChat or purely AI applications, Tencent's move appears to be an intention to seize the entry point of AI applications, taking an offensive approach to ensure it maintains an important traffic entry in the next generation of platform era.

Currently, although the user timeshare in the Tencent ecosystem is still over 30%, it is slowly shrinking. Therefore, if ByteDance relies on Doubao to seize the entry point, Tencent will have to launch an offensive and prepare early.

The number of paid users for value-added services decreased by 3 million quarter-on-quarter during the off-season, mainly due to losses in Tencent Video, live streaming users, etc. Additionally, with not many new mobile games, the number of paying players in games may also have a normal seasonal decline.

II. Games: Current small super, revenue has slowed down

In the fourth quarter, online game revenue was 49.2 billion, a year-on-year increase of 20%. In addition to the incremental contribution from DNFM, new games include the domestic "Delta Operation" and the overseas "Path of Exile 2." Furthermore, some evergreen games have achieved year-on-year growth through operational adjustments based on last year's low base.

Domestic Local Market grew by 23%, accelerating compared to the third quarter. Although market expectations were not low, in the fourth quarter, with not many new games, it still achieved revenue assurance through the selection of quality products, aligning with the strategic direction set at the beginning of last year.

Overseas Games grew by 15%, also exceeding expectations. Originally, market expectations were not high, but the company mentioned last quarter that while Q3 overseas game revenue was missed, the actual revenue was quite good, thus this was released in the fourth quarter.

The revenue indicators calculated with deferred income better represent the forward-looking indicators of real demand. In the fourth quarter, deferred income grew by 16% year-on-year, but decreased quarter-on-quarter. The overall value-added service revenue was calculated at 72.5 billion, a year-on-year increase of 9.2%, which can indirectly reflect the seasonal weakness of revenue (as there is also the impact of Tencent Video's weakness). Therefore, while producing quality products, the number of new games, especially new mobile games, should not be too few.

Looking ahead, the second half of this year is expected to face high baseline pressure from DnFM, but there are still many promising games in the existing reserves. Several evergreen games showcased their strength during the Spring Festival, so it is possible that high growth in games can continue.

In horizontal comparison with peers, although the market is recovering in the fourth quarter, Tencent still has a slight advantage. China's game exports are also experiencing a "harvest period," but it is clear that the major contributions still come from Tencent.

III. Advertising Reappears Alpha Super Ability

We all know that in the past two years, with the rise of video accounts and mini-program games, Tencent has faced adversity, but the advertising business has an alpha logic. However, as the low baseline digital effect weakens, even with video accounts and mini-programs, it is difficult to counter the increasingly severe environmental impacts due to the realistic pressures of the macro environment in the fourth quarter and poor data from channel research, the market's expectations for advertising revenue are relatively conservative, mostly around 12%. However, the actual performance showed a growth of 17%, with the gross profit margin increasing by 1 percentage point year-on-year to 57.7%, a historical high.

It is worth mentioning that the high operating cost of video account advertising is no longer a drag but has become the second largest contributor after Moments advertising. Dolphin Research roughly estimates that the revenue scale of video account advertising in the fourth quarter (mainly from external circulation + e-commerce, with mutual selection advertising accounting for a low proportion due to net income recognition) may have approached 8 billion, a year-on-year increase of 50%, accounting for 20% of total advertising revenue.

The better-than-expected advertising performance is a concrete manifestation of Tencent's Alpha logic (social traffic is the cornerstone, with incremental sources compared to peers coming from video accounts, mini-programs, search ads, etc.). With policies intensifying and the macro environment accelerating to the bottom, along with AI-enhancing algorithm technology, it is expected to improve the not-so-high ROI within WeChat, bringing more tailwinds.

IV. Jinke Enterprise Services: Payment Under Pressure, Opportunities for Cloud Business in the AI Era

In the fourth quarter, Jinke Enterprise Services grew by 3% year-on-year, with a slight recovery quarter-on-quarter, in line with market expectations.

Dolphin Research simply breaks it down: the payment revenue, which accounts for two-thirds, may still be under some pressure (referring to the trend of the total amount of third-party reserve funds collected by the central bank, the financial report disclosed that it is roughly stable year-on-year, indicating a flat performance), but the enterprise services (cloud business and video account commissions, etc.) show a more obvious acceleration trend. In the future, driven by AI, the cloud business is expected to return to the pre-restructuring expansion pace at a faster speed and higher gross profit margin level.

Payment is a pro-cyclical logic, and currently, it mainly depends on the effects of macro policies, especially in the offline catering market where WeChat Pay has a larger share. In terms of market share, at least from the perspective of payment transaction volume, WeChat Pay's share in mobile consumption payments continues to show a steady upward trend. After Taobao Pay broke through, WeChat also has further potential to increase penetration in the e-commerce sector (market expectations suggest that if the GMV of WeChat Pay transactions reaches 20% of the Taobao system content, it means that WeChat Pay can generate an additional annual revenue of 6 billion).

Under the short-term weakness in payments (growth flat), the incremental growth in the fourth quarter still comes from the commissions of video accounts and cloud services (merchant technology service fees, enterprise WeChat commercialization), while the incremental demand for AI may only be more clearly reflected in the performance of the first quarter of this year.

V. Investment Gains: Derived from Stable Reductions in Invested Companies + Financial Profit Sharing Income

Regarding investment gains, Dolphin Research, based on the original indicator definition, mainly looks at the net other income (which includes investment income according to the original definition) and the share of profits from joint ventures/associates:

1) Net other income of 3.56 billion, continuing to maintain significant growth quarter-on-quarter, mainly due to the increase in the fair value of certain assets and asset disposal income.

The fair value gains and losses generally follow market trends, but asset disposal income reached 2.2 billion in the fourth quarter, with nearly 13 billion in disposal income for the whole year, significantly accelerated compared to last year's scale of 4 billion. This aligns with Dolphin Research's expectations from early last year: Repurchase pressure + a lack of investment in new technologies like AI have prompted Tencent to maintain a high willingness to dispose of assets.

2) In the fourth quarter, the share of profits from joint ventures/associates was 9.25 billion, mainly reflecting the profit situation of Tencent's invested but non-controlling brother companies over the past two quarters, such as Pinduoduo, Kuaishou, etc.

However, it is worth mentioning that since Tencent's financial report is generally released before those of its brother companies, this data does not fully represent the actual profit situation of the invested companies. Tencent will estimate a value based on the data it tracks and collects, and then adjust between quarters (for example, if overestimated in the previous quarter, it will be underestimated in the next quarter) to align with the actual profit situation of the invested companies.

Therefore, one cannot simply estimate the profits of Pinduoduo or Kuaishou based on the current share of profits. However, the trend can still be referenced, as several brother companies have been continuously working on cost reduction and efficiency improvement for a year.

As of the end of the fourth quarter, the total scale of the company's joint/associate assets was 297.4 billion, combined with the current share of profits of 9.2 billion, resulting in Tencent's investment return rate for the third quarter being 3%, slightly improved quarter-on-quarter. Overall, since 2022, it has shown a positive trend.

6. High R&D expenses, accelerated capital expenditure, and short-term profits may continue to be affected

In the fourth quarter, the adjusted net profit attributable to the parent company was 55.3 billion, higher than the market expectation of 53.3 billion, but the actual outperformance was not from the core business. If we look solely at the operating profit of the core business under GAAP, it was 49 billion in the fourth quarter, which is lower than the market expectation of 50.1 billion, and the profit margin also dropped by 2 percentage points quarter-on-quarter. The main difference in expectations lies in R&D expenses.

The overall gross margin in the fourth quarter remained stable, with the advertising gross margin exceeding expectations and reaching a new high (deepening commercialization of video accounts). The gross margin for value-added services decreased quarter-on-quarter, mainly due to seasonal factors and high revenue sharing from DnFM. The overall gross margin for JinKe Enterprise Services remained stable.

R&D expenses and Capex both rose, increasing by 18% year-on-year, mainly due to a surge in server costs (+69% yoy) and an increase in R&D personnel salaries (+15% yoy, with 1,735 new hires this quarter, a significant portion likely here). In the previous quarter's commentary, Dolphin Research had already indicated the arrival of a new investment cycle.

In Q4, R&D expenses were 4 billion higher than market expectations, and adding back the overall profit of the core business also significantly exceeded expectations. This mainly stems from Tencent's efforts to control the other two expenses, with a decrease in sales and management expenses year-on-year in the fourth quarter despite fewer new games.

Since the fourth quarter, Tencent has mobilized the entire group to promote AI initiatives, with nearly 100 billion in Capex and plans for some potentially promising projects in gaming. We expect R&D expenses to continue this growth trend. Other expenses will also be controlled as much as possible, but they will still affect the original improvement pace of profit margins.

However, from a long-term perspective, Dolphin Research still believes that Tencent's leverage effect has not been fully realized. This is not only reflected in the optimization of an organization with over 100,000 people (the efficiency of mature business personnel is not high), but also in the linkage between various businesses along the same industrial chain, reducing friction costs at the group level, and the transformation brought about by new AI technologies, which leads to overall efficiency improvements.

Seven, ignoring the revaluation benefits, the major shareholder's reduction in holdings has not slowed down.

Finally, let's take a brief look at the repurchase and selling situation. From the perspective of repurchase volume, after the policy bottom on September 24, Tencent's valuation rose significantly, and the repurchase in the fourth quarter also quickly slowed down, resulting in a quarter-on-quarter decrease of HKD 12 billion in repurchase. In the fourth quarter, a total of 5.8 million shares were repurchased, costing HKD 23.8 billion, and the repurchased shares have been canceled, resulting in a quarter-on-quarter decrease of 0.76% in total shares.

However, at the beginning of January, after Tencent was placed on the U.S. Department of Defense sanctions list, the company immediately entered a buying frenzy, continuously scooping up HKD 1.5 billion every trading day for five consecutive days.

Compared to our statistics in November, the major shareholder Prosus sold 61.3 million shares from November 13 to the present over the past four months, and with the expansion of trading volume, Prosus's selling pace has also accelerated. However, due to Tencent's stronger repurchase and cancellation efforts, as of the end of the fourth quarter, the major shareholder's ownership ratio slightly decreased to 23.7%, with its net asset/share price = 60%, which means a discount rate of 40%, which is an improvement compared to November.

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