TENCENT Performance Outlook: Games expected to see continuous quarter-on-quarter acceleration

From TF Securities.

Tencent will release its financial report on August 14.

Overall Performance:

Revenue growth recovery, profitability continues to improve. It is expected that in 2Q24, revenue will increase by +8% year-on-year, gross profit by +20% year-on-year, and Non-IFRS net profit attributable to the parent company by +36% year-on-year.

It is expected that Tencent's revenue in 2Q2024 will be approximately RMB 161.9 billion, up by +8% year-on-year, with growth picking up compared to 1Q2024. Game growth is starting to recover, advertising continues to maintain high year-on-year growth, and FBS revenue growth rate has declined compared to the previous quarter.

We estimate that Tencent's overall gross profit in 2Q2024 will be approximately RMB 85 billion, up by +20% year-on-year; the overall gross profit margin will be 52.5%, up by 5.1 percentage points year-on-year, and relatively stable quarter-on-quarter. The proportion of high-margin incremental businesses (including revenue sharing from mini-games, video ads, high-margin financial technology products, and live streaming technical service fees) is expected to continue to increase.

We estimate that Tencent's Non-IFRS operating profit in 2Q2024 will be approximately RMB 57.3 billion, up by 25% year-on-year; the Non-IFRS operating profit margin will be around 35.4%, up by 4.6 percentage points year-on-year, and down by 1.3 percentage points quarter-on-quarter. Considering the launch of the heavyweight new game "Dungeon & Warrior: Origin" in the second quarter, we expect that sales expenses in 2Q2024 will increase compared to the previous quarter, but overall may still be lower than the level in 4Q2023 (when "Dream Star" was launched).

We estimate that Tencent's Non-IFRS net profit attributable to the parent company in 2Q2024 will be approximately RMB 51.1 billion, up by 36% year-on-year; the Non-IFRS net profit margin will be around 31.6%, up by 6.4 percentage points year-on-year, and slightly up by 0.1 percentage points quarter-on-quarter. We expect that the growth of Non-IFRS net profit will be faster than the growth of operating profit in 2Q2024, mainly due to: 1) expected improvement in the profitability of some key invested enterprises, and 2) the continued year-on-year improvement in the profit and loss of joint venture companies in 2Q2024. 2) We expect that the high base of the Non-IFRS tax rate in 2Q2024 will decrease year-on-year, or gradually return to the normal range.

Online Games: Expected sequential acceleration in domestic/overseas game revenue for several quarters

We expect the company's online game revenue to increase by +10.5% year-on-year, with domestic market revenue up by +9.6% year-on-year and overseas market revenue up by +13% year-on-year. Looking ahead, we expect Tencent's game business revenue to experience sequential acceleration for several quarters, which is expected to drive market profit growth expectations and sustained increase in risk appetite.

1. For domestic games, "Dungeon & Warrior: Origin" ranked first on the iOS game bestseller list for 63 out of 73 days since its launch on May 21. With reference to the traffic scale of "Honor of Kings," we expect its incremental contribution to be significant, and Tencent's domestic game revenue is expected to experience sequential acceleration for 3-4 quarters.

2. For overseas games, the outstanding performance of "Brawl Stars" drove a +34% year-on-year increase in overseas game revenue in 1Q2024. Since April, its ranking on the iOS bestseller list in major markets has further improved compared to the first quarter. In addition, Supercell's new game "Squad Busters" was launched globally at the end of May. Considering the deferred revenue cycle of overseas games, we expect Tencent's overseas game revenue to also experience sequential acceleration for several quarters

Online Advertising: We expect revenue to increase by +19% year-on-year, with momentum continuing; Expected gross margin to rise to 57%

We expect 2Q2024 advertising revenue to increase by +19% year-on-year and +12% quarter-on-quarter, mainly due to continued healthy growth in video traffic, orderly expansion of advertising, and improved advertising effectiveness on the AI technology platform. We anticipate the gross margin for the advertising business in 2Q2024 to increase to 57.3%, primarily driven by the peak season for e-commerce in the second quarter, with the proportion of high-margin video advertising expected to further increase.

FinTech and Enterprise Services: We expect revenue to increase by +6% year-on-year, with macro consumption slightly impacting the growth of FinTech

We anticipate a 6% year-on-year increase in revenue for FinTech and enterprise services in 2Q2024, with growth slightly lower than in 1Q2024, mainly due to the slowdown in macro consumption. We expect the growth rate of FinTech service revenue in 2Q2024 to fall to a low single-digit level. The gross margin for the company's FinTech and enterprise services has continued to increase from 27.1% in 4Q2021 to 45.6% in 1Q2024, driven by the recovery of operating leverage due to the warming macro demand, the restructuring of cloud business driving margin improvement, and the rapid development of service fees for video-driven product sales. We expect the trend of increasing business gross margin to continue in the medium term.

Investment Recommendation:

The high-margin incremental business of the company has laid the foundation for the continuous improvement of the gross margin, with the outperformance of domestic/overseas game revenue implying an accelerated quarter-on-quarter growth in game revenue for the next several quarters.

We have raised our forecast for Non-IFRS net profit attributable to equity holders for 2024-2026 to RMB 209.1 billion / 239.6 billion / 269.1 billion (previously forecasted as RMB 204.7 billion / 235.6 billion / 264.8 billion), with year-on-year growth rates of 33% / 15% / 12% respectively.

As of August 4, 2024, the company's stock price corresponds to forecasted PEs of 15x / 13x / 12x for 2024/2025/2026, with the 12-month Bloomberg rolling forward PE being lower than the median of the past 5 years by 1.4 standard deviations, at the 8th percentile of historical values. Relative to the Nasdaq, the 12-month Bloomberg forward PE is lower than the median of the past 5 years by 1.5 standard deviations, at the 9th percentile of historical values, indicating a relatively low valuation.

We expect game growth to begin recovering in 2Q2024, and with performance improvement, share buybacks are expected to help alleviate valuation constraints. We maintain our target price of HKD 476 and a "Buy" rating.

Risk Warning:

Uncertainty in macroeconomic growth; Uncertainty in the launch of new games; Commercialization pace of AI technology slower than expected