China's Gaming Crackdown Is Tencent's Major Headwind Going Into 2019

Tencent Holdings Limited TCEHY has had a horrifying year so far, thanks to a slowdown in online gaming due to a stalled approval process in China and stringent regulations.

The company, along with NetEase Inc NTES, is among the biggest game distributors in China. Tencent also operates WeChat, China's dominant social network that has more than 1 billion users.

Online games accounted for almost 32 percent of Tencent's third-quarter 2018 revenues, which declined 4 percent year over year to RMB 25,813 million. The decline can be attributed to a slump in PC and smartphone gaming revenues.

Moreover, sluggish VAS revenue growth (almost 55 percent of revenues) and unfavorable revenue mix hurt Tencent's results. The ongoing shift toward lower-margin smartphone games has been eating into VAS gross margin. Higher content cost of video streaming subscriptions also hurt profitability. These factors along with lower interest income from payment business dealt a major blow to the stock.

Notably, Tencent has lost more than $200 billion in market value since its peak in January. The stock has lost 27 percent this year compared with the S&P 500 Composite's decline of 4.7 percent.

Stalemate Situation

China is the world's largest video game market in terms of users (527 million) and revenues. However, a halted approval process, saturated market conditions and intensifying competition from short video apps like Douyin and Kuaishou have been major deterrents in 2018.

Notably, the State Administration of Radio and Television, which is in charge of monitoring games and other entertainment content, stopped giving new licenses since March 28. The held-up approval resulted in estimated revenue loss of almost $1.4 billion till October-end, according to SuperData Research, as quoted by The Wall Street Journal.

Further, in August, the Chinese Education Ministry announced plans to limit the number of online games and the amount of time kids spend playing on electronic devices. The ministry cited the measures as part of government's effort to reduce eye-related problems.

Moreover, increasing regulatory crackdown compelled the company to shut down its popular Everyday Texas Hold'em poker game. Tencent also pulled down Monster Hunter: World from its WeGame platform.

Tencent is yet to receive full approval to introduce PC versions for two of the world's hot favorites — PlayerUnknown's Battlegrounds (PUBG) and Fortnite. It is also not been authorized to monetize the mobile version of PUBG.

Although PUBG's growing popularity is a big win, the free game is cannibalizing other higher revenue-earning games for Tencent. Moreover, the ongoing user transition to mobile gaming from PCs is expected to hurt the top line in 2019.

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