Life behind the great firewall of China
The number of Chinese internet users has increased at a pace to rival the growth of the overall Chinese economy. Internet connectivity, rising wealth levels and a state party endorsed focus on technology-enabled wealth creation has seen Chinese consumers take to the internet, and internet enabled media, like fish to water. Chinese consumers spend about 8 hours a day consuming media, which pales in comparison to Americans who consume about 12 hours of media every day (Figure 6). Chinese consumers punch above their weight class when it comes to mobile app usage though, matching the US’s almost 3 hours of daily app usage.
Figure 6. Chinese daily media consumption. Source: CNNIC. Statista. Northstar Asset Management. May 2019.
Tencent lays claim to about 51% of those three hours of screen-time for a captive audience of roughly two billion internet users (Figure 7). Tencent has not even begun to monetise their user base as aggressively as its US counterpart Facebook, earning about 60% of what Facebook does per user. With most of the firm’s revenues coming from in-app purchases on free-to-play games and subscriptions to social services.
Figure 7. Consumer time spent on apps. Source: TalkingData, iResearch. Northstar Asset Management. May 2019.
WeChat super-app ecosystem
At the center of Tencent’s new media empire is their ‘superapp’ WeChat (Figure 8). An instant messaging application wherein users can play mobile games, download music, stream videos, hail a cab, share a snapshot of their day, pay their bills or do some online shopping.
Figure 8. WeChat’s ecosystem. Source: Tencent. Northstar Asset Management. May 2019.
WeChat is a classic example of network effects in action (Figure 9). Each incremental new user on the WeChat application increases the overall usefulness of WeChat. And as WeChat becomes more useful it attracts even more users, further improving its usefulness.
Figure 9. WeChat’s virtuous cycle of scale. Source: Tencent, Northstar Asset Management. May 2019.
Tencent then opened up WeChat’s network to third party developers, merchants and advertisers who want to sell things to these users, capturing and creating value for both the supply and demand side of the marketplace. In addition to the entertainment and advertising component of WeChat there is the “industrial internet” (Finance, Cloud and Investments) part of the equation. WeChat Pay is the engine of small to medium commerce in most of China. It is the cheapest method for merchants to accept online or offline payments and removes all friction for users who no longer have to re-enter card info into each app or have to carry a wallet with them for offline transactions. This fuels further adoption of WeChat, evidenced by the 600 million daily transactions completed through their platform and solidifies their 40% market share of total transaction value in China (Figure 10).
Figure 10. Chinese payments duopoly. Source: iResearch, VISA, Northstar Asset Management. May 2019.
Tencent’s ability to monetise its network is not limited to only developers, advertisers or merchants but extends to companies which they have invested in. A prime example of this would be Pinduoduo (PDD), a Chinese ecommerce startup which was funded by Tencent and launched in 2016. PDD targeted lower income consumers in rural areas by making use of WeChat buying groups which purchase bulk orders of consumer staples for near wholesale prices. Integrating closely with WeChat’s ecosystem resulted in rapid adoption and by December of 2018 the total value of all goods transacted had reached $70bn (growing at an average rate of 400% per year) and translating into 5% of total Chinese market share. This makes PDD the fastest growing ecommerce company in the history of Chinese internet and that is almost entirely attributable to Tencent’s network.
Consumer services hiccup hints at the larger Chinese regulatory risk
The most recent overhang on Tencent’s growth prospects appears to be the same force which propelled its initial growth, Chinese regulations. The impromptu restructuring of the Chinese government’s content regulator in 2018 led to an almost year-long stall in the release of Chinese gaming titles, slowing industry-wide growth to 6% YoY, down from 33% the year before. There have been other state interventions into the Chinese gaming industry in recent history and one should not be surprised should another intervention occur.
Chinese regulatory risk does extend beyond temporary disruptions to Tencent’s operations. The Chinese technology industry is protected from direct foreign ownership, as such, when one purchases a share of Tencent stock, one is actually purchasing the rights to ownership of a shell corporation which is incorporated in the British Virgin Islands. This shell corporation’s only assets are contracts which entitle it to cash flows from Tencent’s operations in China (at the discretion of management and the Chinese government). The legal standing of this structure is a grey area which has the potential to be exploited by the Chinese government and could potentially result in a worst case scenario of Tencent’s share being worth zero to foreign investors. We are of the view that this is a real risk but one to which we apply a very low probability given that any Chinese government interventions would impair the ability of Chinese companies to raise foreign capital, which in turn, would materially and irreversibly affect China’s overall growth prospects.
A worthwhile investment into a fast growing sector
Tencent is a fast growing behemoth in a structurally sound industry with a deeply entrenched competitive advantage. We believe that Tencent will continue to deliver outsized returns by leveraging its strategic advantage and high adaptability.