Tencent: Between Regulation and a Hard Place

Generally speaking it is bad practice to bite the hand that feeds you. But sometimes, like in the case of Tencent, you couldn’t even if you wanted to.

Gloom? Doom? Nay. Tencent’s upcoming title!

In under a decade, Tencent has managed to become an all-powerful force in the worldwide gaming market. The firm generates approximately $24bn in gaming revenues annually and (if we exclude revenue from hardware) it is the largest game company in the world. Based on its publishing earnings, Tencent is several orders of magnitude larger than companies likes Activision Blizzard, Electronic Arts, and even platform holders like Sony and Microsoft.

An important part of why it has managed to become such a big deal in such a short time is that it has been able to enjoy the safety and comfort of the Chinese market. Since their inception, Tencent and several of its rivals have had exclusive and protected access to a billion consumers. As the Chinese market adopted smartphones over the past decade, Tencent managed to become even bigger even than Facebook , if you can imagine.

To a large degree it did so on its own strength. Two factors in particular have been critical to Tencent’s success. First, it correctly identified and acquired several incredibly successful properties. Both Riot Games and Supercell have proven to be game makers that put out titles that appeal to hundreds of millions of players and consistently rank at the top grossing. Tencent also has a 40 percent stake in Epic Games (maker of Fortnite), and recently replaced Vivendi as a majority shareholder in French publisher Ubisoft. Bringing all those games to the Chinese market has been highly profitable and has helped fuel Tencent’s market dominance.

Second, Tencent has been on the receiving end of Chinese regulation that demands foreign content firms partner with a local entity in order to gain access to the Chinese gamer audience. As digitalization removed physical distribution limitations, game makers focused on publishing their titles globally. And when Activision sought to bring its tailored Call of Duty Online to China, it allied itself with Tencent. This in itself is a notable occurrence: here is the largest North-American publisher and it has to play nice with what is essentially a competitor, both paying it a fee to being its local connection and inevitably exposing part of its strategy in the process. All upside for Tencent.

But now things are changing. The most important one, perhaps, is that the Chinese government is reorganizing how it approves what games are granted access to its market.

Where the Chinese government previously facilitated Tencent’s unrivaled growth by creating artificial barriers to the Chinese market, it now taketh away. Following a revamp in the approval process combined with an organizational overhaul, game makers now require not one but two thumbs up: Tencent has to get approval for both content and commercial strategy (aka how it plans to monetize a title). By itself this shouldn’t be that big of a deal if it weren’t for the enormous backlog in titles awaiting the two-part approval.

Next, mobile gaming is maturing. Or, more apropos, following the popularization of interactive entertainment and the now ubiquitous presence of smartphones, the underlying dynamics of the games market are changing. Cases like Pokémon GO and Fortnite provide evidence to the idea that, like music and film, success in mobile gaming is quick and explosive rather than a gradual increase in momentum. Earlier titles like Candy Crush Saga, for instance, took a long time to reach the zenith of their success. Pokémon GO, by comparison started on a high note followed by a steep decline.

It has not gone unnoticed among game makers. This shift in post-release dynamics indicates that after a period of relatively unfettered access to a growing consumer market, mobile games now more closely resemble the traditional blockbuster approach we know from the console and PC markets. Recently, Perfect World’s CEO, Robert Hong Xiao stated: “The games industry has entered a mature period and no longer sees wild growth.” Tencent faces much stiffer competition domestically in the form of NetEase and Perfect World as it seeks to grow its value-add services.

And, finally, Tencent’s PC business has been largely flat year-over-year. Worse, the popularization of PUBG and Fortnite have had a negative impact on its cash cow League of Legends. Make no mistake, the game continues to perform among the top titles in the market. But it has lost about 12% of its user base over the past year, not in the least because of the rapid rise to success of games that appeal to a similar audience. Extra salty is the notion that with over a million pre-orders Monster Hunter: World is critical in revitalizing its PC gaming business. But Tencent was forced to halt its much-anticipated title. And being similarly unable to monetize PUBG and Fortnite, the company is currently sitting on some of the most popular titles in its history without the ability to capitalize on them.

Even so, there’s not much Tencent can do about anything. According to its earnings last year it draws less than 10% of revenues outside of China. It has instead taken a proactive approach and continues to comply. Not surprisingly, since the peak in its market cap last November, Tencent has declined. It claimed a -19% decline in gaming revenue q/q in its most recent earnings report and now confronts several important changes to how it does business. Since the firm grew up relatively protected from international market competition and managed to benefit from strong headwinds, especially its gaming business is having a much harder time.

Into the cloud

Based on the recent job openings it seems that the Chinese giant is planning a cross-platform rollout that includes Mac/iOS, Windows and Android devices. We’ll see, I suppose, but Riccitiello from Unity has already expressed support. After Google’s announcement at GDC, I’m a little surprised by how small scale Tencent’s effort is so far. Tencent already runs cloud operations which generated $864MM (RMB 6bn) in revenues in the first nine months of 2018, and more than doubled y/y. Let’s get this popping.

Following the recent government-induced slowdown in games revenue, Tencent has been put on notice. It now knows that it needs to diversify its portfolio if it wishes to continue to grow and, more importantly, keep a comfortable distance between its operations as a firm with global ambitions and its domestic regulators. Despite some movement in title approvals, things are still pretty anemic. In response Tencent has been shifting focus to other revenue areas, including advertising. According to a recent earnings report, “social and others advertising revenue was RMB11.1 billion, up 61% year-on-year and up 19% quarter-on-quarter.”

I have no doubt that Tencent can play a significant role in cloud gaming in China and across Asia (where it may very well partner with Sony and Nintendo), but I’m curious to see whether they’ll roll it out in western markets as well. That would truly be the start of something.

The implications are substantial. Since its peak of $577bn a few months ago, Tencent has lost about $170bn in market cap. This further weakens its competitive position with Alibaba, as Tencent needs capital for its war chest. And as the Chinese government is seeming creating even longer delays in the approval process, it is likely to hold repercussions for companies whose P&L include a large exposure to gaming revenues.

Where government regulation previously helped Tencent grow, it is now hindering its business. In Chinese, the literal translation of the expression “don’t bite the hand that feeds you” is, interestingly, “don’t forget favors and betray justice.”

Even almighty Tencent couldn’t if they wanted.

I’m an academic and entrepreneur with expertise in video games, wrote One Up, teaches at @NYUStern, was @_SuperData CEO (exit)