Tencent Holdings may not be a superhero after all.
Revenue at the Chinese social media company missed estimates by the largest margin in more than three years, user growth slowed and margins are under pressure.
It’s about to get worse.
Masking these troubles in the company’s fourth-quarter numbers was a sevenfold increase in “net other gains,” a catchall category that included gains from the IPOs of companies it has backed such as Sea, Sogou and Yixin Group, as well as tax rebates, subsidies, and dividends from investments. Tencent folds all these items into operating income, which is how it managed to post net income that beat estimates and boost its operating margin by 7 points, all despite the fact that its gross margin dropped 6.4 percentage points to the lowest in at least a decade.
By stripping out the entire “other gains” category — which I think should be reported under non-operating items anyway — I found that rather than climbing, operating margin slid from 29.4% a year ago to 26.8% in the most recent period. When revenue jumps 51% but operating margin slides, you start to realise that economies of scale aren’t quite what you imagined.
Investors should be concerned. WeChat, Tencent’s ubiquitous messaging service, hit 1 billion users earlier this year. There’s not a lot of upside to that figure, which means Pony Ma, the founder, chairman and CEO, needs to extract more money from each existing user.
In recent quarters, he increased the marketing budget while sacrificing R&D growth. In January, I sounded a warning about that same scenario at Alibaba, the Chinese-media wolf dressed in e-commerce clothing, which now spends more on marketing than research. When an increase in marketing budget outpaces a rise in revenue, what you have is diminishing returns on promotions. Tencent hasn’t reached that stage yet, unlike both Alibaba and NetEase Inc., which has pushed recently into e-commerce.
Instead, to reignite growth, Tencent will boost spending on content, AI technologies, retail and fintech. “These investments will probably negatively impact our near-term profitability” but provide payoffs in future, Ma said in a conference call. This kind of spending isn’t the same as marketing because, in theory, it creates tangible products and services, although there is the risk that Tencent will need to boost promotions in the future to drive traffic to these new offerings.
Such a boost will hit margins, though, so those historically low gross margins are likely to get lower while real operating margins — not the figure hidden by investment gains — will probably also narrow.
This means that having spent the past decade transforming into China’s unbeatable giant, Tencent and its shareholders are about to find out what it’s like to feel a little pain.
This column does not necessarily reflect the opinion of Bloomberg LP and its owners.