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Tencent under pressure to find new games strategy

Search for revenue beyond core business likely to affect profitability

HONG KONG -- The phenomenal success of mobile games once helped China's Tencent Holdings land on the list of the world's 10 most valuable brands, alongside Apple and Facebook. But as analysts are waiting for Tencent's earnings report this week, many believe the company's greatest asset could become its greatest burden.

In August, the Hong Kong-listed social media and gaming company reported its first quarterly profit dip in 13 years, triggered by Beijing's suspension on the approval of new games. For those who expect to see a recovery in Tencent's third-quarter financial earnings -- scheduled to be released on Wednesday -- the experience is likely to be another disappointing moment, analysts warn.

Chinese regulators have yet to signal an intention to approve new mobile games. Mobile games, as well as other forms of online gaming, contribute roughly 40% of Tencent's total revenue last year of 237.76 billion yuan.

In fact, the regulatory barriers facing Tencent have grown in recent weeks.

To help restore investor confidence, Tencent President Martin Lau said in August that Beijing had set up a so-called green approval process through which they still allowed some selected gaming companies to cash in on their new title for one month by testing. "That's acted as a relief for the entire industry," he said.

But last month, Beijing closed the so-called green channel without reason, shutting down the last official way for Chinese gaming companies to cash in on their new titles.

"The shutdown of the green channel has hampered market confidence," said Chenyu Cui, an analyst in Shanghai with global consultancy IHS Markit.

Although the one-month monetization brought limited financial benefits to companies, "the green channel served as a reassurance to the market that Chinese regulators would resume game licensing very soon. But they do not have that confidence anymore," Chenyu said.

At stake is Tencent's share price. Once the most valuable company in Asia, Tencent has turned into one of the world's worst performers this year, with its market cap tumbling by a third since January.

As analysts watch Tencent earnings on Wednesday night, they will want to know how the company plans to navigate the lengthy freeze on new game approvals.

"That has been the No. 1 concern in the market right now," said John Choi, head of China and Hong Kong internet research at Daiwa Capital Markets in Hong Kong. "That's the uncertainty that has been clouding the stock itself for such a long time."

Choi said that while it is not clear when the regulatory uncertainty will lift, there is talk that it could happen at the end of this year or early next year. "That will be the key indicator the market will be looking for," he said.

Tencent executives told analysts in August that the company still has 15 new titles in the pipeline that have already received licenses and could be monetized immediately. But even so, there is concern over whether Tencent can sustain its revenue growth in a near-mature market, and at what cost.

In the first three quarters of this year, sales of video games in China reached 145 billion yuan ($20.8 billion), according to the Ministry of Industry and Information Technology. While this represented 20.6% growth on the year, it was lower than the increase of 21.1% during the same period last year.

Without naming Tencent, Kern Zhang, an analyst with gaming-focused market research company App Annie, told the Nikkei Asian Review that gaming developers in China will have to "take a cash-burning approach" -- essentially, spending to win higher revenues.

"To attract new users, gaming companies will either have to spend more on producing higher-quality games or pouring money into marketing and promotion. Basically, it is burning money to win over users," he said.

Since fewer new gamers are joining the market and smaller gaming companies are already out of business, the competition among remaining players has become fiercer than ever, Zhang said.

With the domestic gaming market losing momentum, an increasing number of Chinese game developers bet on overseas, with notable success. Statistics show that in the third quarter of this year, about 60% of 22 mainland-listed gaming companies that disclosed their earnings reported revenue growth on the year.

However, analysts say such a strategy is unlikely to work for Tencent.

"Tencent also performed well in the overseas markets during the third quarter, with its revenue growing by at least 20% against the 2017 levels based on our estimates," said Chenyu of IHS Markit. But "the increased revenue from international players alone is not sufficient to turn the tide, given the substantial size of the company," Chenyu said.

Tencent is apparently aware of that problem. In September, it announced a restructuring plan that has put high-tech sectors such as cloud computing, artificial intelligence and fifth-generation wireless networks at the center of its future development, in a move to seek revenue outside gaming while aligning the company more closely with Beijing's preferred industries.

In a letter to his employees and business partners, Lau said, "Tencent's mission is to become a digital assistant to all industries."

Harry Yuen, an associate director at Hong Kong-based Oceanwide Securities, said, "The restructure and repositioning into 'digital assistant' surely is a great change for the business model of Tencent." But what seems worrying, according to Yuen, is the immediate impact of the restructuring.

"In the short term, these changes will surely affect the profitability and the valuation of the company, as they won't generate as much profit as for the gaming industry," Yuen said.

Martin Bao, an analyst with ICBC International in Hong Kong, shared similar concerns.

"Tencent has adjusted its business focus to cope with the lackluster growth in the gaming sector, but its new services such as 5G and AI require substantial investment and cannot generate a return in the next 18 months," Bao said.

All of these concerns are likely to weigh on Tencent's financial results. "For now, the market expectation for Tencent remains quite low," Bao said.

Nikkei Asian Review deputy editor Dean Napolitano contributed to this story

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