Should You Worry About Tencent's Declining Margins?

Tencent Holdings (NASDAQOTH: TCEHY) stock has had a challenging year, made worse by an underwhelming second quarter earnings report. While the company boasted 30% revenue growth in the quarter, non-GAAP operating profits only increased 11% as operating margins fell year over year to 30% from 35%. Those would be terrific results for just about any other company, but Tencent -- the leading Chinese tech conglomerate and 2017's market darling --- must meet much higher expectations.

Upon closer inspection, the two primary culprits behind Tencent's margin decline appear to be: 1) a ban on Tencent's ability to monetize two of its key video games; and 2) increased financial regulation related to the company's digital payments products. So have these headwinds created a buying opportunity, or is there more difficulty to come?

The ban on Monster Hunter and PUBG

The trouble started earlier in the year when Tencent released a mobile version of "PlayerUnknown's Battlegrounds," a game it licensed from South Korean developer Bluehole. "PUBG", as it's often called, is already available for consoles and PCs worldwide, but Tencent licensed the game for Chinese distribution and adapted it to mobile, the highest-growth format in the region.

The problem isn't the popularity of the game but rather the fact that Chinese regulators haven't allowed Tencent to monetize it. PUBG is free to play, but players can buy in-game items, which is how the publisher makes money. While the exact reason for the delay has not been revealed, according to the The Wall Street Journal, some suspect Chinese regulators are exercising an unofficial sanction on South Korea for installing a U.S. missile defense system last year.

The problem got even worse when the Chinese authorities next blocked the sale of "Monster Hunter" just one week after it was released on Aug. 8. According to the regulators, complaints about the game's content were the cause of the ban this time. On the recent conference call with analysts, however, Tencent claimed:

It's curious that the regulator would approve the game for monetization without having approved the content, but Monster Hunter marks the second time Tencent has run into issues when licensing a foreign title.

Even the Chinese regulatory body responsible for game approvals is undergoing upheaval, as the old entity was disbanded to be replaced by a newer, state-run agency called SART (State Administration of Radio & Television). The organization is still in transition and has approved no new games since March.

Management emphasized that it has already received pre-approval for monetization of 15 other games in its pipeline, and that the regulator, aware of its financial impact on the industry, has created an expedited approval process for games to be monetized on a month-to-month trial basis. Because PUBG is already so popular, however, it still has to go through the official process.

Online gaming is hugely important to Tencent and made up roughly 34% of last quarter's revenue (even without monetization), so it's important that the logjam is eventually cleared. Right now, I suspect this is just a bureaucratic delay and not more nefarious general censorship ... but that's still not entirely clear.

Digital payments get government intervention, too

Chinese regulators are also throwing up roadblocks for Tencent's burgeoning payments business. They had previously taken a lax approach to fintech, which enabled Ten Pay and AliPay to become the two dominant digital payments platforms in China.

Now, however, the People's Bank of China (PBOC) has grown more cautious and is mandating that these platforms hold customer deposits in non-interest bearing, liquid accounts. In the past, Tencent was able to invest this "float" in commercial bank reserves or money market accounts, generating interest income. Given the huge amount of deposits Ten Pay and Alipay hold (roughly $75 billion), that made a difference to Tencent's payments segment profits.

Should you worry?

I wouldn't worry about PBOC regulation on investing customer deposits -- it's all part of the process of becoming a large, responsible financial institution. And while I am somewhat concerned about the unpredictable nature of the new Chinese media regulator, I can't imagine that China would stifle the growth of one of its "prodigal son" tech stars.

So while the current waters are rocky, it appears Tencent's competitive position and growth opportunity remain intact. Invest accordingly.

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Billy Duberstein owns shares of Tencent Holdings. His clients may own some of the companies mentioned. The Motley Fool owns shares of and recommends Tencent Holdings. The Motley Fool has a disclosure policy.