Tencent’s Highest-Growth Business Deserves Your Attention

Shares of Tencent (NASDAQOTH: TCEHY) recently tumbled after the Chinese tech giant's second-quarter numbers missed analyst estimates on the top and bottom lines. The main culprit was the slowing growth of its video game unit, which was hurt by delayed approvals for PUBG and Fortnite, an abrupt ban on Monster Hunter: World, and the temporary suspension of all video game license approvals in China.

That news sounds dire, since online games generated more than a third of Tencent's revenue during the quarter. However, Tencent's social networking, advertising, and streaming media businesses remain strong, and many investors seemingly overlooked the strength of its "other businesses" segment, which grew revenues by 81% annually to 17.5 billion RMB ($2.54 billion) and accounted for 24% of the company's top line.

Let's take a closer look at these "other" businesses, why they're outgrowing Tencent's other units, and how they could offset its slowdown in video games over the long term.

What are Tencent's "other" businesses?

Most of Tencent's "other" revenues come from its payment and cloud businesses.

Tencent has two main payment platforms, Tenpay and WeChat Pay (also known as WePay). Tenpay is a PayPal-like feature that was developed for Tencent's older messaging app, QQ. The platform was eventually expanded to its newer mobile messaging platform, WeChat, as WeChat Pay (also known as WePay and Weixin Pay). The two platforms are now often referred to as a single payments platform.

Last year, Analysys International reported that Tenpay/WeChat Pay controlled 40% of the mobile payments market in China, making it the second-largest payments platform after Alibaba-backed Alipay. Analysys estimates that Alipay still controls 53% of the market, but that represents a steep drop from 70% in 2014.

Tencent integrates WeChat Pay into its growing ecosystem of WeChat mini programs and online-to-offline services, which offer food deliveries, online shopping, ride-hailing, and other services to the messaging platform's 1.06 billion monthly active users. Alibaba integrates Alipay into its own Taobao and Tmall marketplaces.

Tencent and Alibaba are both investing in or partnering with a growing list of retailers, which offer special discounts to WeChat Pay or Alipay users. Therefore, both companies are well poised to profit from China's evolution into a cashless, mobile-first market. Both Tencent and Alibaba's affiliate Ant Financial (which runs Alipay) offer microloans and wealth-management products.

Tencent also owns the third-largest cloud infrastructure platform in China after Alibaba Cloud and China Telecom's cloud platform. Tencent Cloud lends out its cloud storage and computing power to small to medium-sized businesses.

Tencent remains an underdog in this market, but it's still landing big partners like IBM and major customers like ride-hailing giant DiDi. Alphabet's Google -- which recently strengthened its ties with Tencent with cross-licensing deals, co-investments, and a WeChat mini program -- is also reportedly mulling a cloud services partnership with Tencent in China.

How fast are the payment and cloud services segments actually growing?

Tencent doesn't disclose exact revenue growth figures for its payment and cloud businesses.

But during the conference call, Chief Strategy Officer James Mitchell stated that the payments unit "sustained strong growth," as offline commercial payment volumes surged 280% annually (exceeding half of its total transaction volume for the first time) and average daily transaction volumes grew 40%. Tencent's total mobile payment MAUs also topped 800 million at the end of June.

Mitchell said that Tencent's cloud services revenue "doubled" year over year and "deepened penetration in key sectors, including finance, Smart Retail and municipal services." Mitchell also noted that the unit "formed strategic partnerships with certain systems integrators to offer customized cloud services and broaden our penetration offline."

Tencent's gross margin for its "other" businesses rose 2.5 percentage points year over year to 24.9%, fueled by the growth of its microloan business, interest income, and other fintech-related transaction fees.

That's a lower gross margin than its value-added services (59%) or its online advertising business (37.4%), but the former actually declined year over year as the latter stayed roughly flat. Therefore, the margin expansion of its "other" business might eventually offset softening margins in its core video game and social networking businesses.

Minding the pitfalls

The growth of Tencent's payments and cloud businesses is encouraging, but investors shouldn't assume it's a silver bullet for all its gaming-related problems. These high-growth businesses still face tough competition from rivals like Alibaba, and tougher fintech regulations could throttle the growth of its microloans and other riskier businesses.

For now, investors should keep an eye on these "other" businesses, but they should remember that Tencent's future still mostly relies on its gaming and online advertising businesses.

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Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. Leo Sun owns shares of Tencent Holdings. The Motley Fool owns shares of and recommends Alphabet (A shares), Alphabet (C shares), PayPal Holdings, and Tencent Holdings. The Motley Fool has a disclosure policy.