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Edited Transcript of 700.HK earnings conference call or presentation 14-Aug-19 12:00pm GMT

Q2 2019 Tencent Holdings Ltd Earnings Call

Shenzhen Aug 14, 2019 (Thomson StreetEvents) -- Edited Transcript of Tencent Holdings Ltd earnings conference call or presentation Wednesday, August 14, 2019 at 12:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Jane Yip

Tencent Holdings Limited - Assistant General Manager IR

* Pony Ma

Tencent Holdings Limited - Chairman and CEO

* Martin Lau

Tencent Holdings Limited - President

* James Mitchell

Tencent Holdings Limited - Chief Strategy Officer

* John Lo

Tencent Holdings Limited - CFO

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Conference Call Participants

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* Alex Yao

JP Morgan - Analyst

* Alicia Yap

Citigroup - Analyst

* Eddie Leung

Bank of America - Analyst

* Chris Chang

Morgan Stanley - Analyst

* John Choi

Daiwa Capital Markets - Analyst

* Binnie Wong

HSBC - Analyst

* Gregory Zhao

Barclays - Analyst

* Jerry Liu

UBS - Analyst

* Piyush Mubayi

Goldman Sachs - Analyst

* Thomas Chong

CreditSuisse - Analyst

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Presentation

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Operator [1]

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Thank you for standing by and welcome to the Tencent Holdings Limited 2019 second quarter and interim result conference call. At this time, all participants are in listen-only mode. There will be a presentation followed by a question and answer session. (Operator Instructions). I must advise you that this conference is being recorded today. I would now like to hand the conference over to your host today, Miss Jane Yip from Tencent. Please go ahead, Miss Yip.

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Jane Yip, Tencent Holdings Limited - Assistant General Manager IR [2]

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Thank you and good evening. Welcome to our 2019 second quarter and interim results conference call. I'm Jane Yip from the IR team of Tencent. Before we start the presentation, we would like to remind you that it includes forward-looking statements which are underlined by a number of risks and uncertainties, and may not be realized in the future, for various reasons. Information about general market conditions is coming from a variety of sources outside of Tencent.

This presentation also contains some unaudited non-GAAP financial measures that should be considered to, but not as a substitute for measures of the Company's financial performance, prepared in accordance with IFRS. For a detailed discussion of risk factors and non-GAAP measures, please refer to our disclosure document on the IR section of our website.

Let me introduce the management team on the call tonight. Our Chairman and CEO, Pony Ma, will kick off with a short overview. President Martin Lau will discuss strategy review. Chief Strategy Officer, James Mitchell, will speak to your business review and our Chief Financial Officer, John Lo, will conclude with financial review, before we open the floor for questions. I will now turn the call over to Pony.

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Pony Ma, Tencent Holdings Limited - Chairman and CEO [3]

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Thank you, Jane. Good evening. Thank you for joining us. In the second quarter of 2019, we sustained solid year-on-year growth in users, revenues and profits. In games, we released successful new titles in several genres and popularized the innovative game, (inaudible), while promoting balanced game play for young players.

In Payment, we widened the business adoption and grew average transactions and total payment value rapidly. In Content, we deepened our exclusive [relationship] with the NBA, the most watched professional sports league in China, and reinforces our position as the leading digital entertainment platform.

Our diversified business portfolio has broadened our revenue streams and strengthened our [games] business in the current challenging business environment. We will continue to invest to enhance our platforms, services and technologies to better support our users and enterprise customers.

I will now share a few highlight numbers. Total revenue was RMB88.8 billion, up 21% year-on-year, and 4% quarter-on-quarter. Gross profit was RMB39.1 billion, up 14% year-on-year or down 2% quarter-on-quarter. Non-GAAP operating profit was RMB27.3 billion, up 23% year-on-year or down 4% quarter-on-quarter. Non-GAAP net profit attributable to shareholders was RMB23.5 billion, up 19% year-on-year or 12% quarter-on-quarter.

Moving to platform update, in Social, combined MAU of Weixin and WeChat increased 7% year-on-year to RMB1.133 billion, benefiting from the wide adoption of Mini programs and Weixin Pay. Smart devices MAU of QQ was largely stable at RMB707 million.

In Games, our new game, Peacekeeper Elite, has become one of the best performing games in China. Users activities increased in our flagship titles, driven by new content and season passes. Internationally, PUBG Mobile grew our global user base.

In Media, daily video views within Tencent video apps increased year-on-year, due to our popular anime series and video clips from hit dramas. We are enhancing short and mini video distribution across Mobile QQ Browser, QQ Kandian and Weixin top stories.

In Payment, we operate the largest payment platform in China, with robust growth in users, merchants and transaction volume. In Cloud, we are the number two public cloud service provider in China, steadily picking up market share amid enhanced competition.

n Utilities, QQ Browser is a key platform for distributing our content feeds. We applied our industry-leading security capabilities to enhance the offerings of our smart industry solutions with the financial, healthcare and retail sectors.

I will now, invite Martin to discuss the strategy review.

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Martin Lau, Tencent Holdings Limited - President [4]

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Thank you, Pony, and good morning, good evening to everybody.

Today I want talk about our leadership in creating and providing high quality content, which is a key strategic asset and capability in our overall content business, and it has fueled the growth of our long video platform. We also provide differentiated content for our short video and mini video platforms, going forward.

Many observers questioned the role of high-quality content, given the recent boom in user-generated content, such as mini videos. We believe high quality content has enduring and persistent appeal, providing users with education, lifelong bonding experiences, immersion and stimulation in a way that is difficult for short form user generated content to match.

While short and mini videos have captured significant time spent, we believe it was mostly additive to internet time spent, as opposed to taking time away from high quality content. The length of user time spent on high quality content such as professional sport, e-sport and popular drama series, content to show healthy growth trends.

Moreover, there are emerging synergies between long and short form content, and we can capture the growing opportunities of both. For example, we are repurposing our high quality content to produce video clips and highlights for mini videos, contributing to rapid growth in short video consumption within our Tencent video application, as well as in our new feeds. Our leading games are also sources of many popular short and mini videos.

We believe we have unrivalled capabilities in terms of producing, curating and operating high quality content. First, we source high quality content both internally and externally. On the one hand, we possess market-leading, in-house IP incubation platforms, such as China Literature Group, Tencent Games, Tencent Video and Tencent Comics. On the other hand, we partner with global best-in-class content providers, such as the NBA, Sony, Universal, Warner, and the BBC, to name a few, to bring their content to targeted audiences in China.

Second, we have accumulated insights and expertise in content management. Our operations team manage, curate and deliver content to the target audiences in suitable formats, coupled with the right storytelling and packaging, while our technology groups ensure smooth content delivery.

Third, we use our content platforms, such as Tencent Games and Tencent Video, as well as our communication social platforms, Weixin and QQ, to bring content to the widest possible user base, with amplifications through social interactions. In turn, the users become enthusiastic fans of the content, creating resonance and loyalty to the IP.

In the next two pages, I'll discuss two case studies to illustrate how we create, curate and enhance high quality content using our platforms. The first one is our novels. With our subsidiary, China Literature, we have become the market leader in terms of incubating online novels and converting them into hit entertainment formats in China.

For example, The King's Avatar, is a popular China Literature novel about an e-sports player, [we have created] (inaudible) drama series and anime series, based on The King's Avatar IP, with each ranked number one of its kind by video views during the broadcast periods. We are also about to release a movie and will develop and publish mobile games based on this IP.

The Master of Diabolism is another novel from a joint venture under China Literature and is especially popular among female readers. We have produced two series of its anime and accumulated generated over 2.2 billion video views on our platform. We also released a drama series based on The Master of Diabolism, which ranked the top costume drama by video viewers in the heavily contested month of July of this year.

Our second case study illustrates our ability to partner with the best content internationally and sharply upsize its China audience base. Since we signed our first exclusive contract with the NBA in 2015, we have helped the NBA to approximately triple its full season audience to 490 million viewers and its average per game live streaming audience to 3.7 million viewers. This growth both boosted the NBA's brand power in China and substantially increased its monetization capability.

On the other hand, it has also contributed to Tencent Sports becoming the top online destination for sports fans. Based on the success of the first contract, we recently announced that we have successfully extended our partnership with NBA for five more years.

Looking forward, we intend to deliver NBA content across high-DAU platforms in live streaming, video-on-demand, short and mini-video formats, with even better innovative packaging. We intend to enrich NBA VIP and membership benefits, including club merchandise and online streaming privileges. And at the same time, we intend to cooperate further with NBA in developing NBA branded local games and eSports events.

So with that, I'll pass to James to talk about the business review.

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James Mitchell, Tencent Holdings Limited - Chief Strategy Officer [5]

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Thank you, Martin. For the second quarter of 2019, our total revenue grew 21% year-on-year. VAS remained our largest revenue segment, representing 54% of our revenue, within which online games were 31% and social networks 23%. Online advertising was 18% of our revenue and FinTech and business services represented 26%.

Looking at value-added services, segment revenue was RMB48.1 billion in the second quarter, up 14% year-on-year and down 2% quarter-on-quarter. Social networks revenue was RMB20.8 billion, up 23% year-on-year and up 2% quarter-on-quarter. Virtual item sales and livestreaming services and games contributed notably to the year-on-year and quarter-on-quarter growth rates.

Our VAS subscription counts increased 10% year-on-year to 169 million, due to the growth of online video and music subscription services, within which video subscriptions were 97 million, up 30% year-on-year and up 9% quarter-on-quarter, due to factors including joint membership promotions with our partners such as JD.com and Meituan-Dianping as well as the popularity of our Chinese anime series.

For online games, total smartphone games revenue increased 26% year-on-year to RMB22.2 billion, benefiting from the popularity of key titles and new releases. Sequentially, smartphone game revenue grew 5% as we launched more games, following the renewal of the banhao approval process, offsetting weak seasonality.

PC client game revenue decreased 9% year-on-year, although cash receipts increased year-on-year. PC client game revenue decreased 15% quarter-on-quarter, due to adverse seasonality.

Focusing on our social networks, Weixin in Q2 continued to enhance their chat experiences and content consumption, boosting user engagement and time spent. For Weixin, we're successfully building out a uniquely vibrant mini programs ecosystem. By providing development tools, access to consumers and monetization opportunities, mini programs help developers and service providers efficiently expand their businesses online.

The number of mid- and long-term mini programs more than doubled year-on-year. Mini programs are also becoming more diversified in natured. For example, content mini programs allow users to conveniently create, upload and share videos, music and news within Weixin. More than a dozen content mini programs have attained over 1 million DAUs. Benefiting from the popularity of mini programs, Weixin broadened its use cases and grew its user time spent.

In our latest upgrade for mobile QQ, we introduced QQ mini programs, within which entertainment and game categories are particularly popular among the QQ users. We enriched the QQ chat experience via enhanced functionalities for video and voice messages and added an extended screen photo format, boosting daily messages by user quarter-on-quarter. And we helped users expand their social graph through an upgraded algorithm to recommend connections based on common interests and shared contacts.

For smartphone games, existing titles and recent releases drove resumed revenue growth. We launched 10 games this quarter, up from one game in the first quarter, including an augmented reality game, Catchya and roleplaying games such as Fairy Tale and Raziel. Honor of Kings increased its revenue year-on-year, benefitting from its use in past initiatives.

Other games that notably contributed to quarterly revenue included earlier releases, such as Naruto Mobile and Red Alert Online, as well as more recent titles such as Perfect World Mobile. Peacekeeper Elite has now exceeded 50 million daily active users and is in early stage monetization, particularly via season passes. However, its revenue contribution this quarter was very small due to our revenue deferral policy.

In July we released three games in different genres, KartRider Rush is a racing car game, Game of Thrones: Winter Is Coming is a strategy game and Dragon Raja is a roleplaying game. The fact that all three games have achieved top 10 positions in the iOS grossing chart in China is a positive sign for our industry, pointing to player demand for a range of experiences, which appear to complement rather than cannibalize each other.

Internationally, PUBG MOBILE attained over 50 million daily active users, while new games Speed Drifter and Chess Rush achieved initial popularity.

For PC client games, League of Legends's new play mode, Teamfight Tactics, has become the clear global leader in the auto-chess category since releasing internationally in June and in China in July, benefiting its daily active users and time spent. League of Legends China cash receipts increased year-on-year due to popular eSports-themed skins. For Dungeon & Fighter we're currently prioritizing enhancing the user experience and putting less emphasis on player spending initiatives for the next few months.

Moving to our online advertising business, segment revenue increased 16% year-on-year to RMB16.4 billion, amidst challenging macroeconomic conditions and increased short video ad inventory supply. We expect these negative factors may continue impacting the industry through the rest of this year.

Sequentially, our advertising revenue increased 23%, benefiting from seasonally high demand from categories such as eCommerce and online education. Our media advertising revenue was RMB4.4 billion, down 7% year-on-year, or up 26% quarter-on-quarter. The year-on-year decrease was mainly due to the absence of the FIFA World Cup this year and the unexpected delay of certain top tier drama series.

Operationally, our mobile video DAU was stable year-on-year, as consumers continue to value the differentiated storytelling and immersive expierences that long form video can provide versus short form video. In April we released season 2 of Produce 101, a highly popular variety show which achieved record ad billings for a Tencent video program.

Our social and others advertising revenue was RMB12 billion, up 28% year-on-year and up 21% quarter-on-quarter. Growth benefited from more ad inventory and impressions, notably the third ad load in Weixin Moments and the ad inventory in our QQ Kandian news feed.

Looking at FinTech and business services, segment revenue was RMB22.9 billion, up 37% year-on-year and up 5% quarter-on-quarter. Excluding the negative impact of reduced interest income on custodian cash advances, segment revenue was up 57% year-on-year and up 7% quarter-on-quarter.

Within FinTech services, commercial payment grew rapidly in terms of users, merchants, transaction volumes and revenue, driving the year-to-year segment revenue growth. Our commercial payment volume grew over 10% quarter-on-quarter.

LiCaiTong grew its AUM over 30% in the past six months to over RMB800 billion as of June, indicating a trend that our users are increasingly keeping money within our payment system. This trend lowers the frictional cost for users to use Weixin Pay and also has the effect of reducing our withdrawal fees and thus our revenue, as well as our bank charge expenses. The overall impact should enhance the vitality of our FinTech business in the long run. We continue to focus on FinTech risk management to sustain long-term platform growth.

Within business services, expanding our industry facing sales teams and enhancing our product offerings enabled us to sign up more key accounts and large contracts, which contributed to rapid cloud services revenue growth year-on-year. Through close partnerships with independent software vendors and resellers, we've also increased our cloud services penetration amongst small and medium businesses.

And with that, I'll pas to John to discuss the financial review.

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John Lo, Tencent Holdings Limited - CFO [6]

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Thank you, James. Hello, everyone. For the second quarter of 2019, total revenue was RMB88.8 billion, up 21% year-on-year or 4% quarter-on-quarter. Gross profit was RMB39.1 billion, up 14% year-on-year or down 2% quarter-on-quarter.

Net other gains was RMB4 billion, down 64% sequentially. Lower net gains from investees and high impairment provision against certain adjustments, which are both non-GAAP adjustments, were the reasons for sequential decrease.

Operating profit was RMB27.5 billion, up 26% year-on-year or down 25% quarter-on-quarter. Net financials were RMB2 billion, up 72% year-on-year and 77% quarter-on-quarter. The increase was primarily driven by greater interest expense as a result of recent fund issuances and ForEx loss.

Share profit of associates and joint venture was approximately RMB2.4 billion, compared to share of losses of RMB3 billion last quarter. On a non-GAAP basis share profit of associates and JV was RMB2.4 billion, compared to share of losses of RMB518 million last quarter, due to improved performance of certain industries.

The income tax expense was RMB3.2 billion, down 10% year-on-year and 33% quarter-on-quarter, mainly due to recognition of tax benefits. The effective tax rate for the quarter was 11.6%.

GAAP net profit attributable to shareholders was RMB24.1 million and GAAP diluted EPS was RMB2.52, both metrics up 35% year-on-year or down 11% quarter-on-quarter. On a non-GAAP basis, net profit was RMB23.5 billion and diluted EPS was RMB2.46, both well up 19% year-on-year and 12% quarter-on-quarter.

Let me walk you through our non-GAAP financial numbers. Operating profit was RMB27.3 billion, up 23% year-on-year or down 4% quarter-on-quarter. Operating margin was 30.7%, up 0.5 percentage points year-on-year or down 2.6 percentage points quarter-on-quarter. Net margin was 27.2%, down 0.6 percentage points year-on-year or up 1.8 percentage points quarter-on-quarter.

Turning to segment gross margin, gross margin for VAS was 52.6%, down 6.4 percentage points year-on-year and 5 percentage points quarter-on-quarter. The year-on-year decrease reflected revenue mix shift to low margin products. Sequentially, margin contraction was a result of higher video content cost and revenue mix shift to lower margin products, such as (inaudible) and licensed games.

Gross margin for online advertising was 48.6%, up 11.2 percentage points year-on-year and 6.7 percentage points quarter-on-quarter. The year-on-year increase primarily reflected rapid growth of social apps. Sequentially, seasonal uptick of the China advertising market contributed to margin expansion.

Gross margin for FinTech and business services was 24%, down 2 percentage points year-on-year and 4.5 percentage points quarter-on-quarter. The absence of the interest income from the custodian accounts per PBOC guidelines since mid-January was the main reason behind the year-on-year decrease. The rapid growth of commercial payment business accounts for the sequential decline.

On operating expenses, sales and marketing expenses were RMB4.7 billion, down 26% year-on-year or up 11% quarter-on-quarter. The year-on-year decrease reflected our prudent cost management initiatives. Sequentially, sales and marketing expenses increased due to marketing activities for new game releases following the resumption of the banhao approval process.

Sales and marketing expense represented 5.3% of quarterly revenue. G&A expenses were RMB12.6 billion, up 28% year-on-year and 11% quarter-on-quarter, primarily driven by increase in R&D expenses and staff force. Within G&A, R&D expenses were RMB7.1 billion, up 24% year-on-year and 10% quarter-on-quarter. As a percentage of quarterly revenue, G&A was 14.2% and R&D was 8%.

At quarter end we had approximately 56,300 employees, up 15% year-on-year and 3% quarter-on-quarter.

Let's take a look at the margin ratios. Gross margin was 44.1%, down 2.7 percentage points year-on-year and 2.5 percentage points quarter-on-quarter. Our blended gross margin contracted due to pull through from reduced VAS gross margin and mix shift to lower margin revenues.

Non-GAAP operating margin was 30.7%, broadly stable year-on-year and down 2.6 percentage points quarter-on-quarter. Non-GAAP net margin was 27.2%, broadly stable year-on-year and up 1.8 percentage points quarter-on-quarter.

Before I close my remarks, I will share some key financial metrics for the second quarter. Total CapEx was RMB4.4 billion, down 38% year-on-year and 3% quarter-on-quarter, of which operating CapEx dropped 43% year-on-year to RMB3.8 billion, because last year we purchased a large quantity of services to support our (inaudible) business expansion. Non-operating CapEx increased year-on-year to RMB602 million.

Free cash flow was RMB20.7 billion, up 27% year-on-year or down 14% quarter-on-quarter. Net debt position was RMB15.8 billion, which has improved 55% compared to last year.

In the second quarter our total cash grew 6% quarter-on-quarter, following payments for annual dividends and M&A activities, while total debt grew 9% quarter-on-quarter due to a recent bond issuance. As a result, our net debt position increased 64% from the previous quarter.

The fair value of our shareholdings in listed investee companies, excluding subsidiaries, was approximately RMB302 billion (sic - see slide 24 "RMB329 billion"), or roughly US$48 billion, compared to RMB310.7 billion or roughly US$46 billion last quarter.

Thank you, we shall open the floor for questions.

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Questions and Answers

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Jane Yip, Tencent Holdings Limited - Assistant General Manager IR [1]

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Operator, shall we have the first question please?

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Operator [2]

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Thank you. We have the first question comes from the line of Alex Yao from JP Morgan. Please ask your question. Please note you are allowed to ask one question each time.

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Alex Yao, JP Morgan - Analyst [3]

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Thank you, management, for taking my question. A very quick one on the advertising outlook in the coming quarters. Can you talk about the macro environment as well as the oversupply situation? I think, James, you mentioned that you expect this oversupply situation will persist into second half of this year.

What are your strategies to address such a market condition and how do you think about the 2020 outlook? Do you think the current oversupply situation will be better? Will there be a new incremental advertising release over the last four quarters or so? Thank you.

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James Mitchell, Tencent Holdings Limited - Chief Strategy Officer [4]

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Thank you for the question, Alex. Our assumption is that the macro environment will remain difficult for the rest of the year and that the situation of the heavy supply of advertising inventory will continue for the rest of the year and potentially into next year. That obviously flows through to some extent into our advertising revenue, particularly on the media side, particularly with industries such as automobiles, real estate, financial services.

In terms of what we can do then, some of these challenges around the macroeconomic situation, around the industrywide inventory supply are not within our direct control. What we can control are factors such as the rate of our own inventory growth, our ability to provide new tools to advertiser, our capabilities in terms of targeting ads to the right users. And those factors also have an impact on our growth rate and so we seek to use those factors to sustain what we view as a healthy, although not super rapid, rate of advertising in the current challenging environment. Thank you.

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Operator [5]

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Thank you. The next question comes from the line of Alicia Yap from Citigroup. Please ask your question.

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Alicia Yap, Citigroup - Analyst [6]

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Hi, good evening, management, thanks for taking my question. My question is regarding the online games. How should we reconcile the discrepancy between our expectation versus the reported games revenue and the deferred revenue growth this quarter? You noted in the press release that the Peacekeeper Elite game has seen some initial success in monetization, but with limited reported revenue in the second quarter, due to the deferred impact. But yet your sequential growth in the deferred revenue really didn't show a very strong number. So we understand it could be really the two different movements of contribution from different games and the timing, but could you walk us through how we should be looking at the provided number to judge or estimate the trend for the quarter and the second half gaming revenue growth?

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James Mitchell, Tencent Holdings Limited - Chief Strategy Officer [7]

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Thank you, Alicia. So in terms of the game revenue trends in the second quarter, as you're probably aware, the second quarter is seasonally a much slower quarter than the first quarter. And if you look at our history, then historically our game reported revenue and the deferred revenue associated with games has often declined quarter-on-quarter from the first quarter. If you look at some of our listed comparables, their deferred revenue associated with games declined at a double-digit rate quarter-on-quarter.

So I think that on our side, the fact that this year's second quarter both our reported revenue and our deferred revenue increased quarter-on-quarter for the smartphone games is actually quite positive and encouraging.

And zooming in on Peacekeeper Elite, then the game has launched strongly. It is generating healthy revenue now from its season passes. However, the very large majority of our Peacekeeper Elite's cashflow generation in the second quarter was deferred to subsequent quarters. So only a minority, a small minority was captured in our reported revenue line. Peacekeeper Elite was not even among our top 10 games in terms of reported revenue in the second quarter.

On the other hand, we saw pretty healthy quarter-on-quarter trends from a number of our mobile games including PUBG Mobile internationally including our new game, Catchya, including Perfect World Mobile. Overall, we were quite happy with the recovery in smartphone game revenue. Obviously it takes some time for what we see to flow through fully into the reported financials, because of the revenue cycle, but the fact that deferred revenue was up quarter on quarter in what seasonally is a slow quarter for deferred revenue I think gives us some confidence on our side. Thank you.

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Operator [8]

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The next question comes from the line of Eddie Leung from Bank of America.

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Eddie Leung, Bank of America - Analyst [9]

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Good evening. Thank you for taking my questions. Could you talk a little bit about your strategy in high-quality content, especially how you decide on being an independent user platform versus investing in certain upstream content providers, given your past experience investing in games studios, for our information?

Then a follow-up question on games. James, could you also give us your thoughts on the potential new entrants from the short video industry? Thank you.

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Martin Lau, Tencent Holdings Limited - President [10]

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In terms of the high-quality content revenue, I would say our platform strategy is to be an all-inclusive platform. We try to include as much content as possible. That you can see with respect to our video platform as well as China Literature. But at the same time, what we find is - that applies to our music platform as well, but what we find in becoming a strong all-inclusive content platform, there are a lot of synergies if we can work with the content providers more closely.

As a result when you look at our games platform, for example, we have been very early on investing in game studios so that we try to establish a very deep partnership as well as close partnership relationships with the content providers, because we felt that once we have that relationship a lot of times what we can do is we can curate the content better. We can take a long-term perspective and invest in the content better. We can understand the content more and we can help the content developers to understand our platform more so that as a whole we can help the content to be more popular within our user base and at the same time for our user base we can contribute more traffic to the content developers. So it's a win/win relationship that we can build once we have a deeper relationship as opposed to just a mercantile relationship.

In almost every single content platform we have tried to find different ways to establish a stronger relationship with the content providers. That is one of the reasons why we have very strong capability in creating, in curating as well as in popularizing the high-quality content.

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James Mitchell, Tencent Holdings Limited - Chief Strategy Officer [11]

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I would say within the games segment, when you look at potential new entrants from mini video players, I think overall, we felt there is already a lot of competitors in the gaming sector. Throughout the history the game industry actually thrives on having a lot of different competition, and to some extent I would say we welcome new entrants to some extent because when people bring in new ideas, this is exactly how we can actually expand the gaming industry. The gaming industry is driven by innovation.

We do believe that in order to be a very strong player in games you require a lot of domain expertise, which took us many, many years to build. At the same time, I would also want to say that for our existing games, especially the very large games, there's extremely strong network effect in the games especially when it's coupled with our social network. That's a unique advantage that we have.

I think overall, we're not too concerned about having more and more players to be playing in the gaming market. I also want to point out that when you are already a player that is making a lot of revenue from ads, the incentive to move into gaming is not extremely obvious. To some extent you are already making a lot of revenue from the gaming industry as a whole. That's what my reaction is.

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Operator [12]

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The next question comes from the line of Chris Chang from Morgan Stanley. Please ask a question.

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Chris Chang, Morgan Stanley - Analyst [13]

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Thank you for taking my call. My question is about the cloud business. I notice that the press release said that Tencent did some partnership, a penetration in a small-and-medium business through close partnerships with independent software vendors. I'm wondering whether the management can elaborate more about the partnerships with software vendors. Are these mainly international or domestic software partners, and in which type of software solutions?

Also, is Tencent interested in developing inhouse software solutions and what type of software solutions that could be? Thank you very much.

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Martin Lau, Tencent Holdings Limited - President [14]

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In terms of our cloud business, as you know - number one, I want to say our cloud business has actually registered very strong growth in the quarter. We believe we have been consistently picking up market share in the past few quarters.

With respect to the mix of the cloud business, we had been traditionally quite strong in terms of getting businesses from internet players. More recently we have also made pretty strong inroads into some of the enterprise sectors including financial verticals, including government verticals. The last piece of the puzzle is building more exposure to the small-and-medium enterprises, which I think over the past couple of quarters we have made good progress.

That progress is mainly made with respect to what you have described, which is building relationships through the ISPs and through the ISPs who have a lot of connection to the different SMEs where you can sell our cloud solutions to them. These ISPs may be experts in a particular industry. For example, they may be experts in the restaurant industry. Some of them may be experts in the financial or retail industry. When we build relationship with them, we can through them cover a lot of smaller players and companies and customers within those sectors.

There are also some companies who are bigger in size. In some of these companies, we have actually invested in them in order to establish a stronger relationship. Take the example of [Donqua] Software or [Beiming]. There are a number of ISPs, larger ones, that we have invested in so that we can go through them in order for us to cover the small-and-medium enterprises.

We also want to point out that another initiative that we've done with respect to the small-and-medium enterprises is in increasing our toolkit for mini programs. When we can provide a set of tools for companies to connect their mini programs to our cloud services then we have a much higher probability of picking them up as cloud solutions.

One more point to add is that in addition to all these initiatives we have also been developing SaaS solutions both on our own as well as working with SaaS providers in China so that we have exposure to SaaS software solutions such as CRM, such as document processing as well as enterprise messaging. We believe our SaaS initiative is another way through which we can cover small-and-medium enterprises in the cloud market.

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Jane Yip, Tencent Holdings Limited - Assistant General Manager IR [15]

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Thank you. Nest question please.

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Operator [16]

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The next question comes from the line of John Choi from Daiwa Capital Markets. Please ask a question.

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John Choi, Daiwa Capital Markets - Analyst [17]

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Thank you for taking my question. I have a question on your marketing expense. This quarter we've seen pretty - it came down quite a bit year over year. I think on the press release it said you guys have reduced on less effective marketing campaigns. Can you guys elaborate a bit more on these initiatives?

How should we think about the spending trend for sales and marketing and also for other OpEx items towards the end of the year? Thank you.

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John Lo, Tencent Holdings Limited - CFO [18]

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I think since the last quarter last year we have very strong control on selling and marketing expenses. In particular we will look at while they're spending, we will look at whether they have been spent effectively and efficiently. If it doesn't meet our threshold, we will cut the entire campaign completely, as opposed to in the past we tended to assign a budget and we just let them finish all the marketing activities before doing a thorough assessment on the ROIs.

I think there are other ways in which we can measure the effectiveness by comparing similar activities between different business groups and between different departments to ensure that we get the best share or have control of those marketing activities.

Also, I think we do have - we do give out budget on a piecemeal basis as opposed to in the past in which we gave out all the budget at the same time. We do review on a monthly basis to ensure that the marketing objectives have been met before assigning the following month's budget for that. That's why you have been seeing a sharp decline in the selling and marketing expenses in the past two to three quarters on a year-on-year basis.

Going forward, of course, this initiative will continue, but at the same time as you understand, those marketing activities can (inaudible) up and down according to needs and demand, and according to how our competitors spend, in particular in some areas just like payment. Like a year ago we have been spending quite a lot on the payment side, but once we get a certain momentum and when compared with spending versus our peers, we tend to spend less and more wisely.

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Martin Lau, Tencent Holdings Limited - President [19]

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I think to summarize, one is a very strong cost-controlled initiative at the Company. Second, I would say there is some - because of the macro environment we can get better deals in terms of advertising and promotions. Thirdly, with respect to certain verticals such as payment, when the revenue of the market gets hit, when interest income were actually taken away, the marketing spend of the different players actually get rationalized a bit, so it's a balancing act. But going forward, we believe that a lot of the fat has been cut already, and when we are ready to promote for new games the marketing expenses will probably go up.

But I think, overall, because of the cost control and the overall market environment, I think it's a much healthier market environment now than before.

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Jane Yip, Tencent Holdings Limited - Assistant General Manager IR [20]

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Thank you, next question please.

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Operator [21]

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The next question comes from the line of Binnie Wong from HSBC. Please ask your question.

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Binnie Wong, HSBC - Analyst [22]

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Thank you, management, for taking the questions. My question is on the video side. So, on the short-form video, thank you for highlighting the differentiation of your short video against your peers in your opening remarks. If we think about how to yield the maximum synergies from your unique advantages in your content creation platform, I guess what it boils down to is how effective and how targeted we can push the right format to your target audience. So, I guess the question is, how much data user insight is the short video team or your technology team can be shared to do better targeting than our peers?

Then, the second question is on the long-form video side. How should we think about to mitigate a negative impact on the media as -- of unexpected drama delays, especially when we are approaching the National Day and there might be more regulatory -- I mean, in terms of the tightening on the content side.

Then, how are we thinking about any operational measures such as any product change in terms of the type of drama to drive ad revenue growth on the media front? Thank you.

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Martin Lau, Tencent Holdings Limited - President [23]

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Well, I think we do have a lot of data about our users, so over time we have been building a lot of technologies in order for us to leverage this data for feeding the right short and mini video to our users. I think so far, the result has been encouraging, especially after the establishment of our PCG, because we consolidated all our tech resources to create the tech platform that can support our long video, our short video, and our mini video.

I think more progress has been made on the short video front, because if you look at the short video growth within our overall platform, it has actually grown very strongly across our QQ Kandian, our QQ Browser, as well as Tencent Video. So, that actually has made very significant progress.

Now, with respect to mini videos, I think it will take some time before we really start to promote our [Weixu]. On Weixu we actually view it as a very strategic product for us. We will be building up the technology, the content curation capability, as well as the ability for us to target the mini video to the different users through a recommended feed over the long run, and as and when our engagement and retention have reached our target, we'll actually start promoting it in a very big way.

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James Mitchell, Tencent Holdings Limited - Chief Strategy Officer [24]

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Binnie, in terms of your question about long-form video and how we mitigate the impact of the unexpected delays to future drama series, I think at a high level we don't necessarily seek to mitigate fluctuations in individual business lines by doing things in adjacent business lines. You saw last year that when our game revenue, which was a much bigger proportion of our total revenue than video, was under pressure, we didn't seek to accelerate monetization elsewhere.

We believe that we have a relatively diversified, broad revenue mix, and one of the strengths of the position we're in is that we can afford to take some hits in the nature of the business and rely on the breadth and depth of our capabilities to move us forward.

So, that's a high-level answer. Now, getting a little but more granular in terms of what the video team are doing in this environment, clearly from a content perspective the difficulty of putting drama series, and especially historical costume drama series on air, we have been doubling down our focus on some other content categories.

So, we've talked a great deal about Chinese anime, where we believe we are the clear market leader now in terms of both production and distribution, and where we can leverage the competitive advantage that accrues to us from our relationship with China Literature as the upstream inspiration for many of these animated TV series. We've been an aggressive investor in documentaries, and then our Produce 101 variety show we think is the highest rating and highest grossing variety show in the market. So, that's on the content side.

On the revenue side, the traditional 30-second spot advertising revenue is under pressure because of macro factors and because of the delays to the drama series. That said, we continue to grow our subscription revenue at a reasonably fast rate, and in the past 12 months we've more than doubled, approximately tripled, the advertising revenue on the newsfeed inside our Tencent Video app, which is less directly tied to individual hit content, and more broadly related to the daily active user base of the app which remains healthy, despite some of the challenges we're facing.

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Jane Yip, Tencent Holdings Limited - Assistant General Manager IR [25]

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Thank you, and the next question, please.

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Operator [26]

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The next question comes from the line of Gregory Zhao from Barclays. Please ask your question.

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Gregory Zhao, Barclays - Analyst [27]

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Hi management, thanks for taking my question. As I think starting from September, JD will put its TeamBuy business towards Weixin level one entry, and we also know Pingduoduo actually leveraged your social network and launched a very unique TeamBuy business model in the past two years. So, I just wanted to check your expectation on JD's new launch on the TeamBuy, and also understand your strategies to balance your resources to your investment company.

Also, a very quick follow-up on the content cost. I think you mentioned you increased your - the cost in shorter video side. So, I specifically want to understand in which area you will spend the money to directly pay for some [MCNs] or some video studios to produce some short video content? Thank you.

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Martin Lau, Tencent Holdings Limited - President [28]

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In terms of JD, we did renew the contract, and they're going to launch a new user experience. We continue to believe that there is a lot of potential with respect to both building an e-commerce system within Weixin, and the level one entry point for users, because I think, as our experience shows, there are a lot of users who actually go into that entry point.

If the entry point is going to be able to provide a great user experience, and at the same time provide great products to the users and have a high retention rate for the individual users, as well as create some additional leverage over our social network, there could be a lot of potential in the level one entry point.

So, we do believe there is potential, and we hope the new product design would unleash some of this potential. I think interestingly you have brought up Pingduoduo, which for a long time, they did not have a level one entry point, and they have been able to leverage the social network to bring great benefits to their own business, which to some extent validates the point that I made, which is there is a lot of potential within Weixin to build a strong ecosystem around e-commerce.

If you see now, we provide a level two entry point for Pingduoduo. I think these two user experiences are actually quite different, and we do intend to provide help to both companies in order to generate the right user experience, as well as the right user excitement according to their differentiated product experience and category management experience.

Now, on content, maybe John, do you want to answer that question?

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James Mitchell, Tencent Holdings Limited - Chief Strategy Officer [29]

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All right, in terms of short video content, a lot of that content is self-generated, and there's not a lot of content (inaudible) in which we pay to (inaudible) or whatever right now.

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Jane Yip, Tencent Holdings Limited - Assistant General Manager IR [30]

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Okay, thank you. Due to the time constraints, may we have the last three questions, please?

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Operator [31]

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The next question comes from the line of Jerry Liu from UBS. Please ask your question.

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Jerry Liu, UBS - Analyst [32]

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Hey, thank you very much. My question is on FinTech. We've seen pretty good revenue growth and margin improvement in this business, but this quarter we also flagged the fact that our users are not withdrawing the cash actually slowed the revenue growth and margins a bit. I just wanted to get an outlook for the next few quarters, maybe next couple of years, as we develop more financial products to marketplace, as we do new services and products in this area. How do we see the revenue growth and margins trending? Thanks.

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Martin Lau, Tencent Holdings Limited - President [33]

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Well, number one, as you have pointed out, the short-term trend is that the user is actually keeping more money within our ecosystem, and as a result the short-term impact is that it affects the revenue, because the users are withdrawing less cash. Since we have already paid for the cost, the banking cost of such cash, when they withdraw less, the margins also get impacted negatively.

Net-net, it's actually a very good trend from our perspective, because it helps the users to be transferring money and paying for services at zero cost when they keep the money within our system. So, the frictional cost has been reduced, so it's actually structurally a great and very healthy trend for the overall payment system, which then brings to the next question, which is over the long run, we do believe the FinTech business has got a lot of potential.

This is something which is, I would say, similar to our social and performance ad. We viewed it as a multi-year growth opportunity, and there is already a very large user base. There is already a very large transaction volume, and a lot of merchants actually rely on the payment platform to actually conduct their businesses. So, by and large, we have a lot of traffic and platform franchise to actually monetize. At the same time, what we want to do is actually monetize through a value-added way, not just increasing the charges, because without that you have still a very competitive environment.

So, in term of going forward, FinTech services, particularly micro-loans, could be quite important. But under the current environment, while there's still a lot of potential in terms of expanding our loan portfolio, we do want to make sure it's expanded in a measured way, so our risk management is actually done in a proper way, especially in the current macro environment.

We try to be erring even on the more conservative side to make sure that we're not exposing ourselves to too much risk and, at the same time, since there clearly is a lot of headroom for us to grow, we want to spread it over a multi-year period rather than try to draw it all in in a short period of time. So, that's how we look at our overall FinTech services.

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Jane Yip, Tencent Holdings Limited - Assistant General Manager IR [34]

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The next question, please.

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Operator [35]

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The next questions come from the line of Piyush Mubayi from Goldman Sachs. Please ask your question.

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Piyush Mubayi, Goldman Sachs - Analyst [36]

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Martin, can I just ask another question on FinTech You talked about the broader direction, you talked about a few specifics. Could you also talk through what's going on with the payment - the competitive landscape at this point? Any new strategies that you're deploying and confirm whether there's been a change of guard from your side.

If I might ask, about two quarters ago you talked about commercial being more than 50%, I that was in fourth quarter. Where are we on that number?

Lastly the gross margins were down about 400 basis points on a sequential basis. Is that a new number we should go with or can we see that potentially bounce back to where we were a quarter ago? Thank you.

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Martin Lau, Tencent Holdings Limited - President [37]

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I think in terms of the overall competitive landscape I think our positioning is still very strong especially in terms of the frequency payment. I think we are the highest PAU as well as MAU payment platform in China. I think the number of transactions that we have is also highest.

In terms of the overall transaction volume of our commercial transactions it has been growing at a faster rate than the overall transactions too. I think the overall positioning is actually quite strong.

In terms of - what's your second question with respect to numbers. We missed that, sorry.

Oh, the payment margin. I think it is a function of many different numbers so I think in the US the payment business is still in a flux of changes particularly with the taking away of the interest and this new change in which we are able to retain more of the cash within the overall system which is having impact on both the revenue and the cost and the velocity of payment.

I think at this point it's hard to make a number at this point in time. I think it will probably take a couple of quarters for us to take a more stabilized view of the business, then we can probably give you a better number.

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Jane Yip, Tencent Holdings Limited - Assistant General Manager IR [38]

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And the final question please.

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Operator [39]

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This is the last question comes from the line of Thomas Chong from Credit Suisse. Please ask your question.

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Thomas Chong, CreditSuisse - Analyst [40]

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Hi, thanks, management, for taking my questions. I have a question regarding our M&A strategies. Given you have talked a lot about content, should we expect our M&A strategies to focus more on music or short-form video going forward or games (inaudible)? Can management give us some direction on how we use our cash? Thank you.

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James Mitchell, Tencent Holdings Limited - Chief Strategy Officer [41]

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Thank you for the question, Thomas. In general, if you look at the total amount of capital we're deploying in investments, then the rate of investment has slowed quite notably from the first half of 2018 to the second half of 2018 and the first half of 2019. That's partly because the amount of capital we're deploying into investments has decelerated after an unusually rapid pace in the first half of 2018 when we were investing in smart retail and game broadcast sites. That's partly also because of the rate of divestments has picked up pretty sharply. In recent months, in some months our rate of divestments has matched our rate of investments.

In terms of where we are focusing then historically for the past 10 years or so we've been quite active investing in upstream content and that includes game studios, that includes TV production businesses, literature and music. That continues but the greater change is that is we have become more active in some of the frontier opportunities particularly enterprise software, also financial technology, education technology to some extent. Health-related technology opportunities.

So overall, we continue to invest but at a more measured pace than at the beginning of last year. As the internet transforms more aspects of everyday life then we feel that Tencent has a role to play in helping that transformation and sometimes we can play that role entirely by ourselves and sometimes we want to play that role in tandem with partners. With some of those partners it makes sense for us to form an equity relationship to deepen and institutionalize the relationship.

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Operator [42]

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Yes, no more questions on the queue. Miss Yip, please begin your closing remarks.

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Jane Yip, Tencent Holdings Limited - Assistant General Manager IR [43]

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Thank you. We are closing the call now. If you wish to check out our press release and other financial information, please visit the visit the IR section of our Company website. The replay of this webcast will also be available soon. See you next quarter.

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Operator [44]

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That does conclude our conference for today. Thank you for participating Tencent Holdings Limited 2019 Second Quarter and Interim Results Conference Call. You may all disconnect now.