It’s been almost two years since I last wrote about Tencent. Since the inception of this blog, Capital Flywheels has had a preference for Alibaba over Tencent (before it was consensus) primarily because Alibaba is not only one of the two dominant ecosystems in China, but because Alibaba/ecommerce has an easier path to go global. The preference for Alibaba over Tencent initially proved to be underwhelming, especially in 2017 but has since proven out.
While Amazon is the world’s largest ecommerce company by market cap (>$1 trillion) vs #2 Alibaba at ~$570 billion, Alibaba actually has far higher GMV than Amazon already. But more importantly, both Alibaba and Amazon still individually control only single-digit % of global retail sales. The penetration opportunity for ecommerce globally remains enormous and is an important reason for my optimism around Alibaba, Sea (Shopee), Shopify, and Mercadolibre.
However, when this blog last revisited Tencent in April of 2018 after an initial bout of trade war related volatility, I argued that Tencent remains one of the premier franchises in China with strong growth prospects both domestically and internationally. Given that Tencent is the world’s largest game publisher/game IP owner, Tencent has a reasonable path to a more global business through games.
While all of that still remains true, we are almost 2 years to the mark and Tencent stock has yet to exceed its levels in April of 2018 or its highs back in January 2018.
Although Tencent is indeed still one of the two dominant ecosystems in China, a lot has actually changed since then.
Here’s what the business actually looked like at the end of 2019:
Tencent still commands the widest reaching ecosystem in China. At the core of the ecosystem are the social networking assets – WeChat and QQ. WeChat has >1 billion MAUs and remains the single most used app in China. In fact, WeChat is the original super app, with the ability to do an enormous variety of functions including: 1/ Messaging, 2/ Moments (similar to Facebook newsfeed), 3/ Ecommerce (through ecosystem partners such as JD and Pinduoduo), 4/ Payments + digital wallet, and many more. WeChat’s utility is essentially infinite after the introduction of mini-programs, which allows other companies to build small apps that can run within WeChat. This has essentially transformed WeChat into China’s digital operating system.
Although companies may be reluctant to give up so much power to WeChat, most companies (other than Alibaba) simply do not have a choice because WeChat is where effectively all Chinese consumers spend their time on. As a result, even companies that historically came from competing ecosystems are compelled to integrated with and create mini-apps on WeChat.
Around this social networking core, Tencent has also built out an incredibly strong stable of businesses including media, fintech, cloud, and, of course, games.
Although Tencent’s ecosystem continues to gather strength, the revenue chart tells quite a different story.
Value-added services (VAS), which is mostly games, has grown but the growth has slowed significantly. Part of this was due to a regulatory crackdown on games in China, but even though the crackdown has eased in recent quarters, games have not returned to strong growth. The slowing growth is more likely a reflection of the maturation of the industry. Whereas, Tencent previously benefited from the rapid growth of smartphones and influx of consumers that are new to mobile and gaming, mobile penetration is now quite high in China. In fact, smartphone sales have plateaued for a few years already. Without growth in smartphone users, Tencent needs to take more money from each existing user, and this is a much harder quest.
A few years ago, the most exciting new area for Tencent was supposed to be advertising. Given the widespread usage of Moments (a scrolling feed within WeChat that is similar to Facebook’s newsfeed feature, which creates a centralized location to view friends/family updates as well as other content of interest), Tencent appeared to have a very easy path to a very large advertising business, especially since Facebook has already shown the possibilities of advertising within an infinitely scrolling feed. What’s interesting is that Tencent has struggled to increase ad loads within Moments. Currently Tencent has 2 ads per day and is trialing a 3rd ad. Despite the very low ad load, very few users find the experience to be good primarily because the ads are not relevant. For example, male users may find ads for female goods. The ad business has grown and is quite sizable, but it has materially underperformed expectations. Over the past year, this business has also been affected by poor macro, which has meaningfully impacted client demand for advertising.
What’s most interesting to me is that the common dialogue around Tencent’s advertising issues almost all seem to be focused on one of the following: 1/ Tencent claims that they are prioritizing user experience and hence do not want to increase ad loads, 2/ Tencent likely has primitive advertising tools and capabilities, 3/ Tencent’s traditional siloed management structure has starved WeChat of necessary user data for ad tailoring…
Despite how reasonable these arguments all seem, I think these arguments are likely wrong.
The source of Tencent’s ailment is likely Alibaba, and more recently, Bytedance (owner of TikTok).
Years ago, when Tencent, Alibaba, and Baidu started down the path towards all-out ecosystem wars, each player looked for ways to leverage the strengths of the others while limiting the power of others to do the same in reverse.
For example, Alibaba was one of the largest advertisers on Baidu search, hovering up all of Baidu’s users for Alibaba’s own specialized search engine. Alibaba focuses on ecommerce, but at its core, Alibaba’s Taobao is essentially a search engine focused on products. Alibaba was able to leverage Baidu’s strengths. But when Baidu sought to index Alibaba’s website for its own search engine, Alibaba blocked Baidu’s web crawlers from indexing Taobao.
Similarly, a few years ago Tencent made the decision to block all links to Alibaba’s ecosystem. The motivation was to prevent sellers on Alibaba’s platform from utilizing WeChat’s social network to funnel users/buyers to Alibaba’s ecosystem. This made sense at the time given Tencent’s direct ecommerce efforts (which were later sold to JD in exchange for an equity stake and partnership). However, this effectively meant that users on WeChat could no longer share links to products of interest.
The more interesting question is to consider how cutting off the largest commerce platform in China impacts Tencent’s advertising business. At a practical level, advertisers advertise in order to generate sales. Advertising is a key way of sourcing potential customers, which can have fairly high hit rate when combined with granular user data. As a result, advertising only has value if it results in purchases. By cutting off Alibaba’s ecosystem, Tencent has likely set back their advertising efforts significantly since advertising on Tencent’s ecosystem therefore has much lower value if it cannot connect back to the place where Chinese consumers most like to shop.
You may be wondering why this is not a particular issue for Facebook or Google in the US, despite Amazon’s size in ecommerce. In the US, Facebook and Google are agnostic and do funnel users to Amazon. But more importantly, in the western world, most advertisers have their own websites in which to conduct sales. For example, Nike does not officially sell through Amazon. However, Nike does advertise and all of those advertisements take you to Nike.com, not to Nike search results on Amazon.com. This is one of the critical differences of the Chinese internet that gets less attention than it should – China never saw robust development of direct brand / commerce websites. Most brands largely sell through Tmall. In fact, most casual observers likely do not know that Tmall is not really a branded Amazon but more like a website builder that allows brands to set up official stores (filling in the function of official websites in the US). By cutting off Alibaba’s ecosystem, Tencent has cut off a material portion of the commercial internet. The good thing is that direct sales is starting to happen, but it is moving at a slow pace. More brands are exploring direct sales through WeChat mini-apps, but Alibaba has created an ecosystem that extends far beyond connecting buyers with sellers. These additional services are valuable and hard to give up.
The second highly disruptive thing to burst on to the scene over the last 2 years is Bytedance. Bytedance is a fast-moving, innovated AI-driven technology company that started off with a newsfeed product called Toutiao. Using AI, Toutiao aims to be the one content feed that can learn and adapt to user interests. With enough data, Toutiao can keep users highly engaged through multiple formats spanning text, photos, and video. While Toutiao grew very quickly, Bytedance’s second major effort has proven to be the most disruptive – Douyin (also known as TikTok outside of China). Douyin is a short video app that has proven to be extremely engaging with a very sophisticated AI algorithm that can ensure users can scroll endlessly through videos that hit the spot. The significant amounts of time that users are spending in the app has led to a massive shift in advertising dollars to Bytedance apps. While other weaker Chinese companies have felt most of the pain, there is no doubt that Tencent has also suffered as well.
Bytedance has done something quite incredible in China – Not only is Bytedance successfully competing against one of China’s dominant internet ecosystems (Tencent) despite coming in as a small player against a very established ecosystem, Bytedance has significant ambitions to do more.
Bytedance is already carrying plans to carve out a piece of the Chinese gaming market, a market that is currently a duopoly between Tencent and Netease:
ByteDance Inc. is preparing a major push into the mobile arena’s most lucrative market, a realm Tencent Holdings Ltd. has dominated for over a decade: games.
The world’s most valuable startup has rapidly built a full-fledged gaming division to spearhead its maiden foray into hardcore or non-casual games, according to people familiar with the matter. Over the past few months, ByteDance has quietly bought up gaming studios and exclusive title distribution rights. It’s embarked on a hiring spree and poached top talent from rivals, building a team of more than 1,000. Its first two games from the venture will be released this spring, targeting both local and overseas players, one person said.
Returning to the original thought – Tencent in 2020 isn’t any less than Tencent in 2018. The truth is Tencent is a far larger and more robust business. However, Tencent is succeeding less than most investors likely hoped and its unclear how much better the situation will be when we look at Tencent 2-3 years from now. The only area where Tencent doest truly seem to have significantly greater momentum than previously assumed is fintech. WeChat Pay not only caught up to Alipay but has exceeded Alipay in terms of usage. Alipay currently still maintains a small lead in commercial payments (e.g. non-P2P), but that lead is likely to evaporate soon.
Despite Tencent’s issues, Tencent is still a highly resourceful company with the potential to fix many of its problems. I’ll be watching closely to see what’s next.
Disclosures: I own shares in TCEHY and BABA. I have no intention of transacting in any shares mentioned within the next 48 hours.