Cost reduction and efficiency improvement will continue in the second half of the year, with high expectations for Video Number (Minutes of Tencent 2Q22 Conference Call)

Management Report

1. The challenges facing the Internet industry have put pressure on our financial data in the past few quarters. At the beginning of the year, we announced that our strategic plan for this year is to actively embrace change and focus on key businesses. Progress in cost reduction and efficiency improvement so far includes:

(1) Closure of non-core businesses such as online education (2) Shrinking underperforming businesses, including loss-making digital content services and social media (3) Strengthening marketing plans and control of capital expenditures, especially in customer acquisition costs. (4) Migrating all domestic content services to Tencent Cloud to reduce group costs. (5) Optimizing employee teams, reducing 5,000 people compared to the previous quarter.

We expect to continue to benefit from cost reduction and efficiency improvement measures in the next few quarters, and plan to take the following actions:

(1) Cloud services: shrink loss-making businesses, focus on self-owned products rather than customized and subcontracted businesses. Especially PaaS and SaaS, promote profit margin improvement. (2) Payment: Manage funds channels to reduce transaction costs. (3) Long videos: Strictly control content spending, focus on investment return rate, reduce Tencent video subscription promotion discounts and improve ARPU. (4) Video number: reduce content procurement, optimize bandwidth and server utilization to reduce video transmission costs.

1. Video Number

Given that more and more advertisers are turning to short video advertising, our video number must seize this opportunity to gain more advertising budgets. This business is a high-profit growth supplement to our existing business scale.

Regarding the progress of the commercialization of Video Number, we released information flow ads in mid-July. Firstly, we sold advertising in basic contract methods. At the end of August, we will add bidding methods and release more advertising space.

The commercialization process of Video Number will be similar to that of Moments, and Moments' advertising revenue reached 1 billion yuan in five quarters. Based on the current traffic scale and strong demand from advertisers for short video ads, we expect the Video Number to grow even faster and become a strong new revenue growth curve.

The video views of Video Number increased by more than 200% year-on-year, mainly due to social sharing and optimization of recommendation algorithms, and the increase in the number of video views recommended by algorithms increased by 400% year-on-year. The number of creators and daily uploads also grew by more than 100% year-on-year. We helped sponsor official accounts of Video Number through a series of on-site concerts, enhancing the relationship between brand owners and consumers.

1. Driving forces for future income improvement

As the macro industry gradually improves, we expect to improve and expand revenue in the following ways:

(1) First, we believe that the supervision of China's Internet industry will gradually become normalized, which is a positive signal for the industry. In particular, the regulation of the platform economy is shifting towards a positive, encouraging direction, guiding the industry towards healthy and compliant sustainable development. For example, games, the resumption of filing numbers helps to revitalize the industry, and we also hope to obtain filing numbers in the future, which will directly promote the growth of our domestic game business. (2) Secondly, our businesses that suffered significant losses during the epidemic and economic downturn are now recovering along with the rebounding economy. Approximately half of our revenue comes from businesses closely related to the domestic economy - financial technology and advertising.

Due to the lockdowns during April and May, commercial payments saw low single-digit growth this quarter, but rebounded to 17-18% growth in June.

The decline in advertising revenues has also stabilized in the second quarter.

Overall, we are confident in the resilience we have shown in facing these challenges, as well as in our ability to seize new opportunities for growth.

4. Gaming Situation

On the gaming front, we are facing transitional challenges in domestic game development. This includes a decrease in the launch of large-scale games, a decrease in user spending, and policies on the protection of minors. During this period, the company is focused on enhancing development technology to strengthen user stickiness.

To better assess and evaluate this, we can look at the duration of our flagship games. Currently, the most popular games in China are competitive and shooting games, and our "King of Glory" and "Peace Elite" have seen an increase in playtime. Although the revenue of "King of Glory" is declining YoY, it still has the highest total playtime among domestic games.

The new game "League of Legends Mobile" is currently ranked sixth in terms of playtime in China, while "Peace Elite" ranks second, and both are increasing YoY. Last year's release, "Guns of Glory: The Iron Mask", ranked fourth in total playtime in the second quarter. The total playtime of these games for adult users is increasing.

In July, we added a simulation management game called "League of Legends Esports Manager", which currently has the highest revenue in simulation games.

Regarding overseas gaming, it is also in a transitional period after the epidemic. The revenue of "PUBG Mobile" has decreased, while "Valorant" has brought incremental revenue. In the second quarter, "Valorant" achieved higher monthly active users and revenue, and is a competitive shooting strategy game. We prioritize gaming fairness over commercial goals, and have also hosted relevant e-sports events.

5. Cloud Services Situation

Cloud services and other commercial services have declined YoY, mainly because we proactively contracted some low-profit contracts, especially subcontracting contracts. Our proprietary products are growing QoQ, especially in databases, big data, and AI. Therefore, due to improved revenue structure and cost reduction, our gross profit margin for commercial services has increased QoQ.

Revenue from TDS QL databases grew by 30% YoY and contributed approximately 5% of our cloud service revenue.

Analyst Q&A

Q: Compared with other video platforms, what are the management's expectations for the potential space of video ad revenue? How do we see the potential of e-commerce within it? With the continuous growth of video accounts, will there be cannibalization within WeChat?

A: The usage time of Video Accounts is about 80% that of WeChat Moments, which is still rapidly increasing. Under similar conditions, the eCPM of Video Accounts may be slightly lower than that of WeChat Moments, but the ad loading rate can be higher. Therefore, in terms of net growth, the potential monetization revenue per minute that users spend on Video Accounts will be higher. Another way to benchmark is against existing short video services. Currently, although Video Account's user engagement time is relatively low, its CPM is more competitive than existing short video services.

"Moreover, we haven't seen the phenomenon of video accounts encroaching on friends' circles, nor did we expect such a phenomenon to occur, as different services target different user needs, just as the growth of Friends' circles did not eat away at WeChat chat."

As far as e-commerce is concerned, we believe that live e-commerce is a potential opportunity but this requires some time. In the long term, we must move from short video to live e-commerce. As time goes on, we have actually established users' live-viewing habits, including very successfully launching some online concerts. Once people develop the habit of watching live broadcasts, we need to develop a program system that can not only bring traffic to some merchants but also attract them through advertising. After that, we need to guide merchants to do live broadcasts for commercial purposes.

After all this is completed, our ecosystem will have an advantage because our mini-programs can actually easily help merchants complete transactions. Our private domain advantage can actually help merchants accumulate their customers and build long-term relationships, which will be the direction of development for live e-commerce.

"Q: First of all, after the relevant departments made comments on the healthy development of the platform economy and the end of the last quarter, can you update us on the progress and emphasize anything?"

A: As for regulations, we have already given some key points in the previous report section. As you can see, recent regulations have been moving towards a more positive direction for the platform economy. "The key information is to promote standardized, healthy, and sustainable development, complete approvals, and conduct regular supervision." The State Council meeting and the meeting in late July have both reiterated this point.

Based on this guiding principle, we have already seen some results.

(1) There have been no new regulations that have substantially negative impact on the industry this year.

(2) Edition numbers have been restored for publication and multiple batches have been released.

(3) Various regulatory departments are actively formulating more platform economy support policies. For example, an interim ministerial-level working group led by the National Development and Reform Commission has been established to promote the development of the digital economy and coordinate policies in strategic areas such as big data and internet+. The Ministry of Commerce has also released opinions on promoting the development of cultural content, such as expanding game approval pilots and cultivating international well-known game brands. That being said, we expect that it will take some time for the support measures to be introduced, and we look forward to seeing more support measures in the near future.

"Q: With regard to good cost control, the growth in operating costs slowed further in the second quarter. Can you talk about the cost trend for the second half of the year?"

A: Regarding costs, I think you've already seen the significant decrease in marketing expenses. In the next few quarters, there is further room for optimization. For example, there is still an adjustment in management expenses (personnel and salary and welfare adjustments) that has not yet been realized in the second quarter. We also mentioned the second batch of spending plans, which are more targeted towards segmented businesses and will take effect in the second half of the year. Finally, we have some high-profit projects, especially the revenue from Video Account. Therefore, we believe that even if the macro environment has not yet improved, we can achieve year-on-year profit growth by implementing these three measures together.

Q: Regarding the macro headwinds seen globally, I know that management has different plans and cost control measures. How will we deal with these macro headwinds in the future? Secondly, since the later control measures are well implemented, will these measures bring income growth?

A: In terms of cost control, we have taken some measures in the first half of this year and some of the results have been reflected in the results of the second quarter. Even if our current revenue remains stable, we believe that we can restore profit growth in the next few quarters.

As far as game business is concerned, whether it is domestic games or international games, they are all digesting various factors and are in a transition period. Our strategy is to accept this and focus on deepening our contact with users, while also focusing on developing our capabilities, especially in the international market. We will focus on user stickiness and product performance, and develop excellent new games. We believe that by next year, game revenue will recover, but game revenue growth is not a prerequisite for profit growth.

Q: My question is more about cloud services. You mentioned the internal strategic shift to focus more on high-quality revenue growth, such as reducing loss-making activities. How long will this last? In addition, we have heard that the macro environment is preventing many customers from deploying cloud services. Have you seen a greater impact? Where else can we further improve profitability? Should we expect the growth momentum of Video Account revenue in the next few quarters?

A: In terms of the cloud, some macro and autonomous factors have led us to reduce loss-making businesses. From a macro perspective, the internet industry is the one most affected in the vertical industry. At the same time, the macro environment has also affected some enterprise clients, even some clients who have already signed contracts.

From a positive perspective, we have reduced loss-making activities, while also avoiding vicious pricing.

In terms of improving profit margins, we currently have a large customer base, and we focus on promoting PaaS and SaaS products with higher profit margins to existing customers in development, operation and marketing. They bring opportunities for revenue, as well as opportunities for improving profit margins and generating profits.

In addition, in terms of cost, we are actually trying to save costs by better managing our supply chain. In some cases, we work closely with chip developers to obtain cheaper supplies. At the same time, we finally moved all domestic internal services to cloud infrastructure, which helped us expand the scale of cloud infrastructure.

Regarding Video Account, the advertising delivery speed of Moments Video Account will be faster. In the next few days, we will launch the Video Account advertising bidding system (end of August).

Q: In 1 to 2 years, besides e-commerce, where do you foresee the application of Video Account advertising in which industries? What kind of impact will Video Account have on the online advertising market? Do you think it creates new advertising demand? Q:

A: The video number is obviously competing with other short video platforms. Advertising clients have budgets for short video ads, which have been divided into two parts (Douyin and Kuaishou). In the future, they will increasingly divide the budget into three parts (Douyin, Kuaishou, and Video Number).

Advertising clients will spend X on online ads, of which Y% will be used on short videos. Previously, we were not part of this Y%, but now we are, and this is where we believe the advertising revenue will come from.

Regarding e-commerce, we did see an increase in e-commerce advertising in June in the second quarter, and overall advertising spending also increased compared to the first quarter. There are many reasons for this, including the popularity of mini programs and changes in China's Internet landscape, meaning that some large e-commerce platforms that previously did not invest much in Tencent channels began to invest heavily in Tencent channels.

Regarding Video Number, advertisers are classified by category, and we hope to have a wide distribution of categories. Therefore, in addition to e-commerce, consumer products including food, beverages, and cars are also important. Advertisers in the automotive sector have developed relatively well in the past few months.

Q:

A: Whether the international game industry will return to growth next year depends on whether the current weakness is caused by the epidemic or by the macroeconomy. Historically, the game industry is not sensitive to the economy. Currently, most of the profits from games are driven by in-game props payments, and some consumers have been playing their favorite games and buying props in their favorite games. When employment or inflation conditions become more difficult, they will continue to play games while reducing their expenses.

We have some games in preparation that we expect to have good feedback, which will be released in China in the next few weeks. In the coming months, we will accelerate our entry into the international market.

Regardless of the recovery of the game business, we can increase overall revenue by developing other businesses.

Q:

A: The monetization of productivity software is definitely an income opportunity, especially in the long term. But in terms of stage, the adoption of productivity tools software has only just begun and requires a longer conversion and education process to get companies to start paying for these productivity software.

In fact, in this conference call, we have switched from the previous live webcast to our own Tencent meeting, so our department has become a paying user of our own productivity products.

As far as business services are concerned, cloud services are the largest part of the business. Currently, we are more focused on ensuring that our gross profit can grow. At the same time, we can reduce the absolute loss of cloud business, which is actually a more recent goal. Seeing an increase in income should at least wait until next year.

Q: Can you comment on the news of withdrawing from the investment portfolio company (selling Meituan)? Have you learned any lessons from the disposal of JD? Against the background of Naspers reducing its holdings in Tencent and long-term investments in strategic areas such as international game SaaS and video numbers, how do you consider the buyback plan?

A: The news article you quoted is inaccurate. Considering that we believe that our stock price and our investment portfolio are seriously undervalued, we will return the earnings to shareholders through repurchase. Therefore, if you look at our repurchase and dividend situation so far this year, you will find that we have returned about US$18 billion to Tencent shareholders.

Our attitude towards investment and divestment is basically neutral. Therefore, from a certain investment perspective**, our focus has always been on repurchasing our own stock, which may continue for some time.

As for how we provide funds for ongoing repurchases and dividends, we have about US$15-20 billion in free cash flow every year. In addition, we also disclosed that the market value of investment assets at the end of this quarter is US$90 billion.

Through JD, we have demonstrated how to effectively manage investment portfolios and give back to Tencent shareholders more.

In addition, we have an unlisted investment portfolio with a book value of more than US$50 billion. We are also looking for opportunities to return capital to shareholders in the form of dividends, distributions, and repurchases from unlisted investment portfolios.

So I think that if you add all of the above together, there are more than US$10 billion in free cash flow per year, and more than US$150 billion in listed and unlisted investments. Relative to our market value of US$370 billion, we have enough to continue dividends and repurchases at a positive rate.

Although we have greatly reduced our holdings in JD, we continue to maintain a very good business relationship with JD. Finally, I believe that our investors have given good feedback on dividends and dividends, which will also encourage us to consider how to continue to return capital to shareholders.

Q: My first question is related to financial technology or payment business. How should we view future revenue opportunities? This is a question most closely related to macroeconomic consumption. How should we view the situation in the second half of the year or next year?

A: In the financial technology business, it is sometimes mistaken that Tencent operates more in virtual services than in entities, so it is not affected by the overall economic slowdown or the overall economic respeeding. But if you look at Western payment businesses such as Visa and Mastercard, you will find that they are clearly closely related to economic activity.

When the Western economy slows down, they slow down a lot, and as the Western economy reopens, they accelerate again. Our payment business is also like this. As we mentioned, when the city experienced an impact from the epidemic in April and May, our payment amount growth slowed to single digits year-on-year, and then accelerated to 10%-20% growth in June, and accelerated again in July. The growth of payment quantity is closely related to the growth of payment revenue. Therefore, as Visa and Mastercard have declined due to the impact of the epidemic, our economy has also experienced a sharp slowdown. We are now seeing a turnaround, and if the Chinese economy accelerates again, our payment business, advertising business and commercial services activities will also benefit.

Q: The second question is about Video Accounts. If the time spent on Video Accounts exceeds the time spent on WeChat Moments, does this mean that Video Accounts will soon surpass WeChat Moments and become Tencent's number one advertising channel in the near future? In comparison with other peers, do you have confidence in achieving the same per capita revenue as other short video services?

A: From a profitability standpoint, we have been placing information flow ads on Video Accounts for several weeks now, and these information flow ads are currently sold on a contract basis. The eCPM brought by these contracts is slightly lower than the eCPM of Moments, but higher than the comprehensive eCPM of two existing short video services.

The bidding system will be launched later this month.

Based on the contract-based pricing of ads currently seen and the enthusiasm of sponsors for Video Account live broadcasts, the eCPM of Video Accounts will be at least on par with China's leading short-video platform.

Q: Regarding cost control, when we launch new games according to plan later, do we need to increase some marketing efforts? So, if we still want to achieve our profit growth goal by keeping revenue flat, does this mean we need to go back to using investment to drive revenue growth?

A: If we launch a new game, we will carry out a series of marketing expenses, but we believe the money is well spent, especially if it is a very important game.

Q: Regarding the issue of increasing video accounts, what is the bottleneck? Or what is the primary factor that determines the speed at which we increase advertising placements?

A: This is a process of continuous optimization and re-optimization, and we have increased the loading rate of ads. We measure the performance of ads and optimize them, and then increase the number of ads each user sees per day.

It took a long time to re-optimize WeChat Moments because it was our first large-scale optimization, and we had no external benchmarks for benchmarking.

However, for Video Accounts, we can complete this climb more quickly because we have benchmarks from Moments for testing and adjustment. I also believe that machine learning, hardware and software are better now than they were then.

Q: What is the synergistic effect of the WeChat ecosystem as a whole? How does it compare to other forms of advertising such as Moments and official accounts?

A: I think we mentioned some synergies in our opening remarks. When an advertiser buys a Video Account, they can link to their mini-program, which is a private traffic environment that they value very much, including the ability to link ads to Enterprise WeChat. Therefore, a consumer interested in high-value products (such as electric cars) can chat directly with salespeople from electric car OEMs or dealerships. Q: Regarding overseas games, there have been reports recently that Tencent may increase its stake in a global gaming company. How should we view the merger opportunities for global games?

A: As far as overseas game distribution is concerned, we have three methods to launch new games.

1. One is through existing overseas investors who bring new games to the overseas market. In the past 5 years, we have invested in a series of other investment projects, such as some projects that investors are not familiar with. But with the success of Rerising, or the expected success of Dark Tide, we believe that more investors will understand the value behind it.

2. Secondly, we have large domestic studios such as Photon, TiMi, and Aurora, who are developing games that will be released in China and overseas.

3. Thirdly, we have been very active in acquiring new game studios. We recently acquired Minicups, which brought the game "Subway Surfers". Subway Surfers has 30 million daily active users, which is actually quite a large scale.

Q: Can you share with us your latest views on the development strategy of FinTech? For example, does Tencent need to apply for a financial holding company license, and whether it needs to establish a separate credit rating unit and apply for relevant licenses? Compared with FinTech peers of comparable size, would you establish your own FinTech business in similar or different ways? Secondly, is...

A: As far as the development of FinTech is concerned, I think it is actually quite stable and developing well. As you can see, FinTech is already a very important part of our overall business.

Over the past year, we have been in contact with regulators to ensure that every part of our FinTech business is fully compliant. As for the financial holding company, we are still working with regulatory agencies on the licensing part. Whether we will obtain a financial holding company license or not will not have a significant impact on our business. In the past year and a half, we have gone through the test. We are very clear about what we need to do to continue to develop our FinTech business.

Q: Can we assume that you achieve the profit of advertising assets in a different way from Moments? Considering the long-term profit potential, would you keep the number of advertisements about the same as your peers on the current market?

A: The profit model of Moments and Short Video is exactly the same, and we put user experience first. As you can see, this priority has paid off, because the video views in Short Video have increased by over 200% YoY.

Starting now, there are some differences in income realization between Short Video and Moments.

1. One difference is that the benchmark for the optimization of short video monetization climbing is much clearer than when we optimized Moments advertisements.

2. The second difference is that both the software and hardware of machine learning are better in Short Video.

The third difference is that the cost of loading ads in short videos is lower than that in social networks such as Moments, because in short videos, if consumers see an ad they don't want to watch, they will swipe it away, **which is why two Chinese short video service providers can maintain a load rate of about 14%-16% of ads. **

And for Moments, we show 3 to 4 ads to each user every day. As not all users will see these ads, the effective loading rate of ads is only close to 2% to 3%. We expect Video Account to surpass Moments in terms of ad loading rates.

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