Tencent (TCEHY) is down 1.6% in U.S. trading after posting mixed Q1 numbers: Non-GAAP EPS of RMB2.19 ($0.32) beat a consensus of RMB1.99 ($0.29), but revenue of RMB85.47 billion (up 16% annually and equal to $12.43 billion) missed an RMB88.41 billion ($12.86 billion) consensus.
Perhaps the biggest positive within Tencent's report: The company's giant online gaming operations, which have been stung badly in recent months thanks to a temporary Chinese government halt on game monetization approvals, did better than expected. While Tencent's online games revenue was roughly flat annually at RMB28.51 billion, it was up 18% sequentially. In addition, gaming cash receipts, which can differ from revenue thanks to the fact that revenue recognition for some gaming transactions is deferred, rose 10% annually.
Meanwhile, though some one-time factors did help out here, slower spending growth and favorable margin trends allowed Tencent to beat EPS estimates in spite of a revenue miss. After dropping 6 percentage points annually in Q4 to 41%, Tencent's gross margin fell just 3 points annually in Q1 (and rose 6 points sequentially) to 47%. Tencent's sales and marketing spend fell 24% to RMB4.2 billion ($611 million) -- on the earnings call, Tencent attributed this to both fewer game launches and "cost management initiatives."
And while G&A spend rose 20% to RMB11.3 ($1.64 billion) billion thanks in large part to a 30% increase in R&D spend, the growth rate slowed from Q4's 29%. Capital spending, which eventually affects gross margin via depreciation expenses, fell 29% as Tencent joins other Chinese and U.S. internet giants in digesting the data center capacity it has built up in recent quarters.
But while gaming revenue was better than expected, annual growth for Tencent's online ad sales slowed to 25% from Q4's 38%, with revenue of RMB13.4 billion ($1.95 billion) falling short of an RMB 14.67 billion ($2.13 billion) consensus. Tencent says that macro headwinds and more difficult annual comparisons weighed on ad sales growth, as did the delayed arrival of "top-tier drama series," which had the effect of lowering its video ad inventory. The drama delays also contributed to subscriptions for the Tencent Video service being roughly flat sequentially at 89 million, with annual growth slowing to 43% from Q4's 58%.
Though an accounting change muddies the picture a bit, it also looks as if combined revenue for Tencent's financial services and cloud businesses fell short of expectations. For Q4, Tencent reported that its "Other" revenue, which included its financial and cloud operations as well as some other businesses such as its film and TV production units, rose 72% to RMB24.21 billion ($3.52 billion). For Q1, the company reports its "FinTech and Business Services" revenue, which covers its financial and cloud ops but not the other businesses, was RMB21.8 billion ($3.2 billion), up 44% annually and roughly flat sequentially.
Tencent attributes this segment's lack of sequential growth to the loss of interest income on "custodian cash balances" that were transferred to the People's Bank of China in mid-January. At the same time, it says cloud growth remained strong, and that monthly active merchants accepting its very popular mobile payment services (i.e., WeChat Pay) more than doubled annually, which in turn drove continued growth in transactions per user.
Overall, Tencent's story still has many positives. Though ad sales disappointed in Q1, it's worth keeping in mind that the company has been taking a measured pace towards monetizing its WeChat app (all but ubiquitous in China), and still has a lot of headroom to grow ad sales for various WeChat services. Likewise, WeChat Pay's momentum still looks good, and gaming trends definitely look better than they did a few months ago.
If there's something to be concerned about here, it's the slowdown in video ad and subscription growth. While a one-time factor (delayed content launches) did play a role here, Tencent is dealing with a highly competitive Chinese online video market, one in which Baidu's (BIDU) iQiyi (IQ) and Alibaba's (BABA) Youku Tudou unit are also formidable players. That makes a quarter of slower growth in this space more concerning here than it would be in fields where Tencent faces less direct competition.
Tencent's stock still doesn't look very expensive in light of its growth opportunities and competitive moats, as well as the value of its massive investment portfolio and the extent to which large investments have been depressing its near-term earnings. But it could take a little while for markets to digest its revenue miss, particularly given that it comes at a time when worries about Chinese macro trends are running high.
