Fresh Regulatory Worries for Tencent

Here’s what happened. On August 3, state-affiliated media in China said that playing online games is addictive and went so far as to call online games ‘spiritual opium’. In the article, the Economic Information Daily was wary of impacts from pop culture, saying "no industry, no sport, can be allowed to develop in a way that will destroy a generation.” Tencent’s blockbuster game Honour of Kings was singled out as an example for causing a detrimental impact to the country’s youth.

Although the state-run media quickly took down the op-ed, the market picked up on it. Shares of Chinese online gaming companies were down substantially on fears that the episode with the after-school tutoring sector will replay with game developers. Tencent’s share price shredded 4.8%. NetEase and CMGE Technology were down 6.9% and 14.1%, respectively.

Overreaction

Ivan Su, senior equity analyst at Morningstar, believes the market reaction on Tencent was overblown for several reasons.

First, the restrictions on playing hours is not new – it has existed for a few years now.

After the official media critique this week, Tencent says it will further restrict minors’ playing hours to 1 hour from Monday to Friday, and 2 hours for holidays. In fact, a milder version of such restriction has been in place for some time now. In May 2020, the government brought in rules that limit the time that underage gamers spend on Tencent’s Honours of Kings. Those under 18 years can play the game for a maximum of 1.5 hours on weekdays and 3 hours on the weekend. In fact, from as early as 2019, teens have been banned from playing between 10PM and 8AM as the government says gaming at night would impair eyesight.

Su says the minimal impacts caused by these rules were reflected on Tencent’s profitability through the last quarter.

Second, Su says that investors should not overlook the typical business model of game development studios.

“Their revenue stream is mostly derived from adult gamers -- in the forms of in-game subscriptions or top-ups. The way for Tencent and peers to monetize a mobile game isn’t likely to change on this news.”

Furthermore, at this stage, no tangible policy changes have been proposed. Su’s fair value estimates of Tencent, NetEase, and CMGE remain unchanged. He estimates that spending by minors represents about 6% of Tencent's gross revenues from the segment, a low single-digit percentage of NetEase's, and an even lower percentage for CMGE. He says, “Even if the government was to impose a blanket ban on underage gaming, assuming an impact on developers across the board, downsides in valuations are capped at about 5%, in our view.”

Back to Fundamentals

This round of correction has made Tencent’s shares more compelling. The wide-moat company ended August 4 at HK$446 and has an appealing 80% upside potential to Su’s fair value estimate of HK$800. Tencent has multiple moat sources, which are some significant advantages that can help it withstand competition over the long term.

According to Su, Tencent’s sprawling network through its all-in-one messenger WeChat has collected a massive user base. Its flagship platform, which comprises payment, a social network and games, has a total of 1.2 billion users. Sticky users and systematic monetization of various verticals are likely to preserve Tencent's economic moat for the next two decades.

Also, the company harnesses intangible assets, such as a vast collection of user behavior data and content/IP ownership to develop games and a social media strategy.

Other than economic moat, Tencent is given an Exemplary Capital Allocation rating, which implies it has been good at channeling resources into profitable projects. In the case of Tencent, the company management is committed to investing in enterprise digital services to tap into demand for cloud services and enterprise software, particularly to meet remote office needs after the outbreak of the coronavirus.

©2021 Morningstar. All rights reserved. The information, data, analyses and opinions presented herein do not constitute investment advice; are provided as of the date written, solely for informational purposes; and subject to change at any time without notice. This content is not an offer to buy or sell any particular security and is not warranted to be correct, complete or accurate. Past performance is not a guarantee of future results. The Morningstar name and logo are registered marks of Morningstar, Inc. This article includes proprietary materials of Morningstar; reproduction, transcription or other use, by any means, in whole or in part, without prior, written consent of Morningstar is prohibited. This article is intended for general circulation, and does not take into account the specific investment objectives, financial situation or particular needs of any particular person. Investors should consult a financial adviser regarding the suitability of any investment product, taking into account their specific investment objectives, financial situation or particular needs, before making any investment decisions. Morningstar Investment Management Asia Limited is licensed and regulated by the Hong Kong Securities and Futures Commission to provide investment research and investment advisory services to professional investors only. Morningstar Investment Adviser Singapore Pte. Limited is licensed by the Monetary Authority of Singapore to provide financial advisory services in Singapore. Either Morningstar Investment Management Asia Limited or Morningstar Investment Adviser Singapore Pte. Limited will be the entity responsible for the creation and distribution of the research services described in this article.