Tencent: Investing wildly without hesitation, the stock king has been "scented" by AI!

Two months later, $TENCENT(00700.HK) released its Q1 2025 performance after the Hong Kong stock market today (Beijing time, May 14). Benefiting from games, advertising, and a recovering payment environment, the performance exceeded expectations.

However, the explosive performance in Q1 was significantly contributed by games. Starting from Q2, the high base effect of the DNF mobile game will begin to exert pressure, which means that overall profit growth will slow down to a new range from a macro perspective. Therefore, whether AI can provide Tencent with the driving force to take off again is also the most anticipated point for bullish funds in the market.

Last month, Dolphin Research discussed Tencent's possible AI strategic route based on its capital allocation (review " Tencent: Starting from the Stingy Buyback, Is Super AI an Obvious Conspiracy?"), and this time, we will do a small deep dive combined with the financial report.

First, let's review the performance:

1. Evergreen continues to exert strength, games far exceed expectations: Q1 game growth was 24%, which is a strong growth even without considering expectations. In addition to the incremental contributions from "DNF Mobile" and "Operation Delta," the two long-standing evergreen games, "Honor of Kings" and "Peacekeeper Elite," performed very well during the Spring Festival due to content updates and operational activities. Overseas revenue continues to see high growth from "PUBG Mobile" and classic games under Supercell.

From the perspective of deferred revenue, the quarter-on-quarter growth rate is higher than the normal level of previous years, which is expected to continue providing some support for Q2. However, starting from Q2, it will inevitably face the high base effect of "DNF Mobile." From the existing pipeline, there are several heavyweight reserves led by "Honor of Kings World," most of which have already obtained licenses, but there may still be some time lag before they can be officially launched this year.

Therefore, under such growth pressure, reliance on evergreen games will also increase. Since entering Q2, "Honor of Kings" has continued to strengthen its collaboration with well-known IPs, such as Nezha. "Peacekeeper Elite" will also welcome a major update this summer, such as adding more content experiences through AI.

2. Strong advertising, speeding up through e-commerce: Q1 advertising grew by 20%, further accelerating on a high base, exceeding market expectations. In the last conference call, the company mentioned that improving the loading rate of video accounts is the core driving force for maintaining advertising growth in an uncertain macro environment this year. Currently, video accounts are the second-largest advertising revenue type within WeChat, with a loading rate of only 4%, which indeed has a significant gap compared to short video peers.

However, the smooth improvement of the loading rate also requires real financial support from advertisers. As is well known, e-commerce merchants are the largest advertisers. Today, the WeChat business group established an e-commerce product department, and the intention behind this is also very clear.

3. Fintech's recovery is within expectations: Mainly driven by some implemented policies. However, given the high uncertainty in the consumption environment, we expect the annual growth to remain slow. But if e-commerce picks up, it will also drive payments, which is precisely where Tencent lacks an advantage in online physical e-commerce payments.

4. AI and e-commerce drive enterprise services: This is mainly driven by the combined demand for AI cloud services and e-commerce commissions. Last quarter, the company mentioned a shortage in AI cloud service supply, and with the acceleration of chip deployment, revenue is expected to grow at over 10%. However, the company's overall strategy prioritizes internal computing power, so there is no need to incorporate too many positive expectations for cloud service growth this year.

The aforementioned e-commerce layout can also bring Tencent an incremental revenue from technology commissions. However, this is not the focus, and it cannot be ruled out that Tencent may significantly reduce this fee to attract merchants, hoping to generate more medium- to long-term value through e-commerce advertising.

5. Operational efficiency continues to support profit margin improvement: In Q1, with good revenue growth, profit margins also improved. On one hand, the overall change in business structure has improved business monetization efficiency (comprehensive gross margin increased), while on the other hand, operating expenses remained stable with low growth. For example, although there were fewer new game releases in Q1, the operational activities of old games were very intensive, yet sales expenses did not increase significantly. This indicates that evergreen games have inherent brand marketing and extreme monetization efficiency. As the leading company with the most evergreen games, Tencent naturally has an advantage over its peers.

Ultimately, Non-IFRS net profit attributable to shareholders increased by 22% year-on-year, with a profit margin of 24%. However, if we exclude the one-time equity compensation of 4 billion due to Ubisoft's business restructuring, the actual profit beats expectations even more. According to the main operating profit indicators tracked by Dolphin Research, after excluding the impact of Ubisoft's merger, the actual year-on-year growth is 22%, maintaining high growth despite a high base.

6. Continuous investment in AI: Regarding cash flow and capital allocation, the focus is on capital investment and repurchase situations. In Q1, due to the strong growth of the two cash-generating businesses, gaming and advertising, the net operating cash inflow surged to 76.9 billion, setting a historical high.

Q1 capital expenditure of 27.5 billion exceeded market expectations and the normal deployment pace (referencing overseas major companies, the initial investment lagged behind the annual planning pace). Although there is a possibility of continuing to buy in advance before the chip purchase restrictions are upgraded, according to the company, investments will dynamically change based on internal demand, indicating strong demand. At the same time, it also shows Tencent's ambition for super AI. As for repurchases, Q1 is generally the least for the year, mainly due to the short gap between the last two financial report release dates, during which the silent period prohibits repurchases.

Ultimately, with more inflows than outflows, a significant amount of cash was retained in Q1, with a net cash of 90.2 billion at the end of the quarter, an increase of over 13 billion quarter-on-quarter.

7. Detailed financial report data overview

Dolphin Research's Viewpoint

The performance in the first quarter was good, with some market expectations for both games and advertising. Especially in the gaming business, according to Sensor Tower data, it can be roughly estimated that the revenue has a year-on-year growth rate of about 25%, but the market remains conservative, likely due to calculations regarding revenue recognition and some caution towards overseas games.

In addition, the continuously weak macro environment and the high base pressure from games in the second quarter may have led some funds to choose to avoid the earnings report, mainly to steer clear of guidance for Q2. This is understandable, as according to the original growth expectation of 25 years, Tencent's valuation is currently implied at a Non-GAAP P/E of 17-18 times, which, although lower than the historical average, is expanding operational expenditures with increased AI investments. The originally fixed return of 5% from buybacks has been halved, now only 2.5%. Therefore, until AI investments yield positive cyclical returns, conservative funds may be hesitant in the short term. This point was already mentioned by Dolphin Research in the last quarterly earnings commentary.

However, this earnings report also reveals Tencent's unexpectedly strong "resilience," which we believe is likely due to AI already generating positive returns on internal operations:

(1) Advertising is invincible under pressure. The overall environment in the first quarter was barely acceptable, but Tencent's advertising revenue itself also faced high base pressure. However, actual advertising revenue accelerated to grow by 20%, with the increased loading rate of video accounts being a major driving force. Merchants generally focus on ROI, and during periods of weak consumption, if video accounts can increase inventory and still receive orders from merchants, it further indicates an improvement in the ROI of video accounts. Coupled with the company's statement in the earnings report: "AI has made a substantial contribution to performance advertising," this is likely where the improvement lies.

From daily perception, the accuracy of WeChat advertising has consistently been low, at least significantly lower than Douyin and Kuaishou. The underlying reasons could be minimal infringement on user data or WeChat's lack of emphasis on advertising commercialization. But regardless of the reason, AI's assistance (marginal improvement) in WeChat advertising should be significantly better than that of Douyin and Kuaishou (which have already reached extremes), similar to the ROI changes brought to Meta and Google by AI.

(2) Evergreen games maintain high stickiness. The continuous development of evergreen games has been one of Tencent's core strategies since the gaming regulation last year. However, the user stickiness of evergreen games can easily be affected by the migration brought by new games launched at the same time, especially for MOBA games. As a major DAU game, a decline in popularity can further worsen the experience for existing users. In the past, there were heavy traces of bot players, but with the new generation of AI technology, users may find it difficult to distinguish between bots and real players, allowing for a long-term maintenance of quality gaming experiences.

(3) Operating expenses controlled against the trend. In the first quarter, the total expenditure for the three main expenses of the core business was 37.5 billion (excluding the impact of Ubisoft's restructuring), with the main optimization being in sales expenses, including the epic promotion of Yuanbao (some external promotion costs), but sales expenditure remained flat year-on-year.

In terms of employee numbers, there was a decrease of 1,144 people quarter-on-quarter. This may include optimization of personnel structure through AI, for example, in terms of R&D personnel expenditures, in Q1 where AI penetration accelerated, the year-on-year growth rate of R&D personnel salaries was 14%, which was lower than the growth rate of the previous quarter.

Combining the experiences of Meta and Google, AI can partially replace comprehensive operational tasks and basic code writing. Therefore, with Tencent's large organizational structure, we might expect more optimizations.

Based on Tencent's consistently shrewd investment level, the unexpected Capex indirectly conveys its attitude towards AI and the smooth progress of its current AI business. Thus, similar to previous views, we believe that although the revenue expansion and internal efficiency improvements that AI can bring to Tencent are difficult to quantify, it may be worthwhile to make some positive adjustments in valuation, such as moving from the current 17x P/E to a relatively optimistic 20x P/E. From a longer-term perspective, in terms of gaining a first-mover advantage in the new generation of industrial value, whether it be traffic, talent, or the strategic vision and reliability of the management team, Tencent is currently a seed player within our field of vision.

The following is a detailed analysis

I. Potential Benefits from AI, WeChat Ecosystem Steadily Expanding

In the first quarter, WeChat users reached 1.402 billion, with a net increase of 17 million quarter-on-quarter. Besides seasonal effects, there should also be a boost from WeChat's red envelopes and WeChat stores. QQ, on the other hand, continues to decline year-on-year, with some rebound quarter-on-quarter due to the Spring Festival. We will see if QQ can stabilize its traffic after the integration of AI.

After the aggressive promotion of the red envelope App at the beginning of the year, the monthly active users of the red envelope App have exceeded 40 million, but there is still a gap compared to the Top 2, Doubao at 107 million and DeepSeek at 97 million. In April, the red envelope was officially integrated into WeChat (previously it was mainly in testing, directly attached to the original red envelope assistant), allowing users to more smoothly call the red envelope through the chat window, which significantly helps improve penetration.

Regarding the super AI strategy, the AI Chatbot is just one application direction. From Tencent's current strategic direction, the entire WeChat ecosystem will also integrate mini-program calls to launch a more intelligent, task-result-oriented AI Agent. The subsequent launch path is worth looking forward to and paying attention to.

In March, the user duration share of Tencent's ecosystem increased quarter-on-quarter, likely benefiting from the red envelope App. However, at the same time, Byte's ecosystem still maintains a leading gap. This also indicates that Tencent and Byte will inevitably have a battle over the next generation's largest traffic entry point

The number of paid users for value-added services saw a net increase of 6 million in the off-season, mainly due to an increase of nearly 2 million for Tencent Music and a net increase of 4 million for Tencent Video, with the remainder coming from Yuewen and live streaming users.

II. Evergreen continues to make strides, games exceed expectations

In the first quarter, online game revenue reached 59.5 billion, a year-on-year increase of 23.6%. In addition to contributions from the mobile game "DNF" and "Delta Force," Evergreen Games played a decisive role in the unexpected growth in the first quarter—local evergreen games like "Honor of Kings" and "Peacekeeper Elite," as well as overseas evergreen games like "Brawl Stars" and "Clash of Clans."

The domestic local market grew by 24.3%, maintaining high growth. During the Spring Festival, "Honor of Kings" leveraged the Year of the Snake skin and collaborated with the Sanrio IP, enhancing user experience through AI, which maintained user stickiness and set a new monthly revenue record. Meanwhile, after a major content update, "Peacekeeper Elite" also saw a significant increase in revenue, which continued into April.

Overseas games grew by 22%, also exceeding expectations. Originally, market expectations were not high, but Supercell revitalized old games through gameplay iterations.

The revenue indicators calculated with deferred income better represent the forward-looking indicators of real demand. In the first quarter, deferred income grew by 22% year-on-year, with a quarter-on-quarter growth rate higher than normal levels in previous years, and revenue grew by 16%, significantly accelerating compared to the previous quarter, which is expected to continue providing support into Q2.

However, starting in Q2, it will inevitably face the impact of the high base from "DNF Mobile." From the current pipeline, there are substantial heavyweight reserves led by "Honor of Kings World." Although most have already obtained approval numbers, there may still be some time lag before they are scheduled to launch, and it is uncertain whether they can be launched this year.

Therefore, under such growth pressure, the reliance on evergreen games will also increase. Since entering Q2, "Honor of Kings" has continued to strengthen collaborations with well-known IPs, such as Nezha. This summer, "Peacekeeper Elite" will also welcome a major update, including more content experiences enhanced by AI

Due to the strong performance of large existing games, Tencent's high growth has provided significant support to the industry, leading to a continued market recovery in the first quarter, both domestically and internationally, following Tencent's lead.

III. Strong Advertising, Future Acceleration Relies on E-commerce

As we all know, in the past two years, with the rise of video accounts and mini-program games, Tencent has faced adversity, but its advertising business has shown alpha logic. However, as the digital effect of the low base weakens, even with video accounts and mini-programs, it is difficult to counter the increasingly severe environmental impacts.

The overall environment in the first quarter was barely acceptable, but Tencent's advertising grew by 20%, further accelerating on a high base. The market has certain positive expectations, but Tencent's actual performance was even better.

In the last conference call, the company mentioned that improving the loading rate of video accounts is the core driving force for maintaining advertising growth in an uncertain macro environment this year. Currently, video accounts are the second-largest source of advertising revenue within WeChat, with a loading rate of only 4%, which indeed shows a significant gap compared to short video peers.

However, the smooth improvement of the loading rate also requires real financial support from advertisers. It is well known that e-commerce merchants are the largest advertisers. The establishment of an e-commerce product department under the WeChat business group today also makes its intention very clear.

According to rough estimates by Dolphin Research (for reference only), the advertising revenue scale of video accounts in the first quarter (mainly from external circulation + e-commerce, with mutual selection ads accounting for a low proportion of net income) may exceed 8 billion, a year-on-year increase of over 50%, accounting for 25% of total advertising revenue.

From daily perception, the accuracy of WeChat ads has consistently been low, at least significantly lower than Douyin and Kuaishou. The underlying reason can be said to be limited infringement on user data, or that WeChat itself does not place much importance on the commercialization of advertising. But regardless of the reason, AI's assistance to WeChat advertising (marginal improvement) should be significantly better than that of Douyin and Kuaishou (which have already optimized to the extreme), similar to the ROI changes brought to Meta and Google by AI.

IV. Fintech Hits Bottom, Corporate Services High Growth Not Urgent

In the first quarter, Fintech's corporate services grew by 5% year-on-year, showing a warming trend within expectations.

Dolphin Research simply breaks it down: the payment revenue, which accounts for 2/3, has already hit bottom and is warming up (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, which means a flat performance), while corporate services (cloud business and video account commissions, etc.) continue to accelerate growth.

In the last conference call, management mentioned that the cloud business is currently limited by insufficient supply (mainly data centers), so the proportion of external leasing is not high, and with limited computing power, this year will prioritize meeting internal demand. This is also the biggest difference between Tencent and Alibaba, Baidu in their AI strategies, fundamentally stemming from their desire to earn different types of money. Therefore, the cloud business may continue to be constrained by supply this year, but we expect a speed-up starting next year.

In addition, corporate services also include e-commerce commissions (only technical service fees). Today's news indicates that Tencent's WeChat Group has begun to establish an e-commerce product department, and WeChat Mini Stores have also become a key discussion point for executives in the financial reports over the past two quarters, indicating Tencent's strategic intentions in e-commerce. However, technical service fees are secondary; advertising is the real goal. It is not ruled out that technical service fees may be directly reduced later to attract more merchants and service providers to settle in.

In summary, although there is a warming trend, Dolphin Research will not blindly inject too much optimistic expectations for Fintech and corporate services this year.

V. Investment Gains Come from Share of Profits

Regarding investment gains, Dolphin Research, based on the original indicator definition, mainly looks at net other income (which, according to the original definition, includes investment income) and the share of profits from joint ventures/associates. In the first quarter, there was hardly any asset disposal, so the comprehensive investment income mainly came from shared profits.

As of the end of the first quarter, the company's joint/associate asset scale totaled 312.6 billion, calculating that Tencent's investment return rate for the first quarter was 1.5%, slightly improved year-on-year. From 2022 to now, it has shown a generally positive trend

VI. Operational Efficiency Improves Against the Trend

In the first quarter, the adjusted net profit was 61.3 billion, higher than the market expectation of 59.7 billion. However, from the perspective of operating profit from core business (i.e., gross profit - three operating expenses), if we exclude the one-time equity compensation expense of 4 billion resulting from the merger with Ubisoft, the actual core operating profit significantly exceeded market expectations, with a profit margin of 35%, an increase of 3 percentage points year-on-year.

Now let's take a look at how such a high profit margin was achieved:

1. Structural Adjustment to Improve Overall Profitability

Gaming and advertising are two businesses with relatively high gross margins, so the continuous high growth of these two gold mines has a good pull on both gross margin and cash flow. The gross margin in the first quarter increased by 3 percentage points year-on-year to 55.8%, setting a historical high.

2. Maintain R&D Investment to Improve Overall Operational Efficiency

Due to AI, the increase in R&D expenses is unavoidable, but the growth rate is not exaggerated. The expenses related to compensation only increased by 14.4%, and the growth rate has slowed down. Expenses related to server bandwidth increased by 52% year-on-year, continuing to accelerate. In the short term, the R&D teams related to AI are still gradually expanding, and the current recognition is insufficient.

However, management and sales expenses, which are not directly related to AI investment, have the motivation for continuous optimization. In the first quarter, the main optimization was in sales expenses. Despite intensive gaming activities and epic promotions of in-game currency, sales expenditures remained flat. Management expenses increased by 17%, but when combined with sales expenses and excluding restructuring costs, the total only increased by 11% year-on-year, which is lower than the revenue growth rate.

In terms of employee numbers, there was a decrease of 1,144 people in the first quarter compared to the end of the fourth quarter. This does not exclude the possibility that AI has optimized the personnel structure. For example, in terms of R&D personnel expenses, in Q1, when AI accelerated penetration, the year-on-year growth rate of R&D personnel compensation was 14%, which was lower than the growth rate of the previous quarter

Based on the experiences of Meta and Google, AI can partially replace comprehensive operational tasks and basic code writing. Therefore, within Tencent's large organizational structure, we can perhaps expect more optimizations.

3. Future expenditure expansion space - Capex pre-investment exceeds expectations

Although investments in AI will lead to an expansion of costs and operating expenses in the future, in the long run, Tencent's investment in AI may yield a higher return on investment. On the other hand, from the current perspective, investing in AI is also a defensive investment to ensure Tencent's leading position in the mobile internet.

In the first quarter, capital expenditure was 27.5 billion, exceeding market expectations and the normal deployment pace (referencing overseas large companies, early-year investments lag behind the annual planning pace). Although it cannot be ruled out that there is a possibility of continuing to buy in advance before the chip purchase restrictions are upgraded, according to the company, investments will dynamically change based on internal demand, indicating strong demand.

VII. returning to growth is expected to offset major shareholder reduction pressure

Finally, let's briefly look at the repurchase and selling situation. In the two months since the last financial report was disclosed, Tencent's total shares have net increased due to employee stock option grants and the silent period preventing repurchases. Meanwhile, the major shareholder's reduction has not weakened, selling nearly 32 million shares in two months, reducing their equity stake in Tencent to 23.3%, a decrease of 0.37%.

In the article "Tencent: From stingy repurchases to super AI as a blatant strategy?," Dolphin Research mentioned that this tariff war exceeded expectations. When the stock price once again plummeted by over 10%, the company did not conduct large-scale repurchases to support the stock price as it did during the previous two crisis moments (the new regulations on online games at the end of 2023 and the Ministry of Defense sanction list at the beginning of 2025). The strategic intent behind this reflects the elephant turning, transitioning from "defense" to "growth" — the importance of AI layout surpasses everything.