Tencent's Assault On Online Gaming

| About: Tencent Holding (TCEHY)
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A few years ago, a Google employee famously asked Senator John McCain on his visit to Silicon Valley during the 2008 election campaign, "So do you remember your GPA at school?" That person was Tom Zhang, now the "talent acquisition expert" at Tencent America, a subsidiary of Tencent Holdings (OTCPK:TCEHY).

The Hong Kong based group that has internet, mobile and gaming subsidiaries, now with a market cap of $57 billion, is one of the largest companies in the industry. It has announced its plans to expand outside of China, particularly in gaming. For the second quarter of 2012, Tencent earned $879 million from online video game sales, a 53% increase over last year while total revenues were $1.6 billion, up 56%.

Online Gaming to Rule them All

Tencent recently purchased a 49% stake in Singapore's gaming company Level-up for $27 million, an online game distributor that is present in the Philippines and Brazil and is pushing into India as well. It has a number of successful free-to-play MMORPG's in its stable. But its big move in the U.S. market was buying Riot Games last year for $400 million and acquired minority shares in Epic Games in June, this year. Although the details of the deal weren't disclosed industry insiders believe that Tencent outbid Warner Brothers, a Time Warner (NYSE:TWX) subsidiary, for Epic Games and its Unreal Gaming Engine which is used in many of the biggest titles in the industry including EA-Bioware's (NYSE:EA) Mass Effect series.

The increase in gaming revenues is notable because usually, in the second quarter, Chinese students are occupied with examinations which results in the seasonal drop in earnings. However, the acquisition of Riot Games in 2010 was a big coup as Riot's flagship title, the online competition-based "League of Legends (LoL)," a mix of Activision-Blizzard's (NASDAQ:ATVI) Warcraft 3 and skirmish level PvP, grew to 32 million players in November 2011 on a freemium payment model. Tencent has taken LoL into Southeast Asia and China.

While in the U.S. games like World of Warcraft dominate the headlines with its peak of 11 million subscribers, many of which were farmers for in-game gold to sell to previously middle-class Americans, free-to-play so-called "Asian Grinders" have two to 5 times those numbers and many of them spend a lot more than $15 per month. The freemium model that was pioneered in the U.S. by Turbine with both Dungeons & Dragons Online and then Lord of the Rings Online has helped push PC-based gaming revenue in 2011 to $18.6 billion, $6 billion of which was generated in China which grew at a 27% rate. The western markets saw revenue drop by 11% overall. Yes, mobile is coming on strong and is expected to generate $8 billion in revenue in 2012, doubling by 2016, but there is still a huge market for games that need a full power computer.

Games That Sell Themselves

Tencent as a whole saw a 32% increase in Q2 profits, with advertising revenues jumping by 80% over last year. This is in stark contrast to other Chinese internet companies that are concerned about falling advertising income. Renren (NYSE:RENN) recorded increasing net revenues of $44.8 million in Q2, up 47.5% YoY, but ad revenue dropped 10.5%.

Tencent's comprehensive revenue strategy has many of the leading firms in the gaming industry lining up to work with the company. It currently has agreements and licensing deals with Zynga (NASDAQ:ZNGA), Popcap, with its popular titles Plants vs. Zombie and Bejeweled, and German based Crytek GmbH, creator of award winning games such as Far Cry and Crisis, to publish content in China. However, investors are eyeing Tencent's deal with the leading US based game developer Activision Blizzard, which gave it a long-term exclusive license to bring Call of Duty Online to mainland China.

It is now the largest game developer in China and boasts the country's biggest online gaming community, Tencent games. 75% of its revenue comes from its "Internet Value Added Services" business unit, while just 9% comes from Mobile, 8% from e-Commerce and 7% from online advertising. It is a unique conglomerate offering a variety of internet services, the likes of which does not exist in the West, but which all have synergies with each other.

Tencent's shares are up more than 55% on the Hong Kong exchange year to date.

China Gaming Revolution

The growth of Tencent symbolizes China's strategic shift from a hub of cheap labor to high tech innovation. Despite the recent acquisitions, Tencent is still looking for other opportunities. It is likely that it will focus on expanding in emerging markets, doubling down on the Philippines and Brazil and looking at other attractive markets like Vietnam, Thailand and Indonesia, which offer more opportunities of growth for an emerging Chinese company rather than the western markets that are deeply penetrated, have intense competition and the costs of acquisition are a lot higher.

Chinese internet companies generally enjoy both direct access to an enormous market size which is host to a quarter of the world's internet population and the famous great firewall of China which creates a brilliant barrier for foreign firms such as Google, Facebook, Zynga or Activision to compete directly, in essence, forcing them to partner with a company like Tencent.

The GlobalX Social Media Index ETF (NASDAQ:SOCL) is heavily weighted towards Tencent, its 2nd largest holding, right behind LinkedIn (LNKD). In fact, the top 5 holdings of SOCL are:

1. LinkedIn 12.82%

2. Tencent 11.65%

3. SINA Corp. 7.19%

4. Google 5.97%

5. DeNA 5.89%

Tencent does not have a sponsored ADR listed on a U.S. exchange, only an OTC unsponsored one, ticker symbol TCEHY.PK, if investor's are interested. This fund has been under pressure due mainly to the fall in Facebook, 5.3% of AUM, from its obscene IPO price. It tracks the Solactive Social Media Index. Now that Facebook's price is more in line with its near-term reality this fund should do very well. Its top holdings are companies that are hitting on all cylinders in this space. It looks to be building a base between $12 and $14 per share.

The majority of Tencent's revenue is coming from an industry with a proven record of generating great returns using low barrier-to-entry payment models while acquiring distribution rights to some of the biggest stand-alone titles in the world for the biggest potential markets. Couple that with a relatively diversified revenue strategy to offset development costs of new games, i.e. ad revenue and social networking, and that's a recipe for solid growth even during a difficult macro environment.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.