Tencent Holdings Ltd

HKEX:700

Earnings Call Transcript 2018-Q2

[Operator]

Thank you for standing by, and welcome to the Tencent Holdings Limited 2018 Second Quarter and Interim Results Conference Call. [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, Ms. Jane Yip from Tencent. Please go ahead, Ms. Yip.

[Jane Yip, executive]

Thank you. Good evening. Welcome to our 2018 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 in addition 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 documents on the IR section of our website.

Let me introduce the management team on the call tonight. We have our Chairman and CEO, Pony Ma; President, Martin Lau; Chief Strategy Officer, James Mitchell; and Chief Financial Officer, John Lo. Pony will kick off with a short overview. Martin will discuss strategic highlights. James will speak to business overview, and John will go through the financials before we take your questions.

I will now turn the call over to Pony.

[Huateng Ma, executive]

Thank you, Jane. Good evening, everyone. Thank you for joining us.

In the second quarter of 2018, we continued to deepen user engagement across our social, games and media platforms with solid year-on-year growth in daily active users and time spent in our Weixin platform, mobile games and video platform. We have also invested heavily in our news feed, short video and mini video product and have seen significant growth in them.

Let me highlight the key financial numbers. Total revenue was RMB 73.7 billion, up 30% year-on-year and stable quarter-on-quarter. Non-GAAP operating profit was CNY 22.3 billion, up 11% year-on-year or down 12% quarter-on-quarter. Non-GAAP net profit attributable to shareholders was CNY 19.7 billion, up 20% year-on-year and up 8% quarter-on-quarter. John will provide more details in the financial section.

Moving to our key platforms. Combined MAU of Weixin and WeChat increased 9.9% year-on-year to 1.06 billion as we are building a vibrant Mini Programs ecosystem with higher developer and user adoption, further strengthening the user engagement of the platform.

Total MAU for QQ was 803 million. Smart devices MAU was 709 million, up 7% year-on-year. Our news feed service, QQ KanDian, further grew its active user and time spent. Our social network services, Qzone, smart devices MAU was 543 million.

In games, we strengthened our leadership in mobile and PC. We increased our smartphone games market share in terms of DAU. User time spent and engagement increased in key genres, including tactical tournaments, action, shooter and mobile. We also expanded our user base globally, benefiting from the success of AOV and PUBG MOBILE.

For media business, we maintained our leadership in online video, news, music services and literature. We solidified our leadership in long-form video platform with higher mobile DAU, user engagement and also larger subscriber base.

In fintech, our mobile payment system -- service deepened its penetration in verticals such as fast-food chains and supermarkets. We'll continue to be the market leader in terms of DAU, driven by rapid growth of offline commercial transactions. In mobile utilities, we remained an industry leader in mobile security, mobile browser and Android app store in China.

With that, I will pass to Martin to discuss strategic highlights.

[Chi Ping Lau, executive]

Thank you, Pony. And good evening and good morning to everybody. I will first start the session by addressing a very popular question, which is the trend of user engagement in our core platforms, especially given the popularity of short videos and mini videos recently in the market. The quick answer is that we have seen increasing engagement in our social platform, games platform, video platform as well as strong growth in our media feeds.

Now starting from social. Weixin recorded solid growth in terms of users, time spent and activities. As the largest social communication platform in China, Weixin continues to add daily active users and per-user messages, both delivering digit -- double-digit growth rates year-on-year. In particular, users are spending more time in Moments as well as Mini Games within Weixin. Through increasing popularity of Mini Programs and Weixin Pay, Weixin is getting involved in more vertical use cases online and offline, enabling us to increase the value of our engagement that is not entirely dependent on time spent. I will elaborate more on Mini Programs in the next 2 slides.

In the area of video, user consumption of long-form video content continues to ramp up, driven by IP-based original content in drama, variety shows and Chinese anime. For mobile, daily active user increased 24% year-on-year, daily video views up 53% year-on-year and total time spent up 39% year-on-year during the second quarter, solidifying our position as the leading video platform in China.

In terms of media feeds, our recommended feeds are getting higher hits due to better algorithm and enhanced content offering. These media feeds are strategically placed in our large DAU products so as to provide more convenient access to users. Currently, QQ KanDian and Mobile QQ Browser host our largest feeds products, and in aggregate, they increased daily page views by 55% and daily short videos view by more than 3x year-on-year.

Now moving on to the next 2 slides. I will discuss the rapid adoption of Mini Programs and how it is enabling our payment business and enriching our O2O ecosystem. Mini Program is an innovative platform built into Weixin, facilitating discovery and consumption of services. For developers, Mini Program offers an open platform with powerful features to make programming easier and more efficient. These programs run immediately upon scanning a unique Mini Program QR code, connecting offline services to online engagement.

Supported by Weixin Pay, advertising and cloud capabilities, Mini Programs can provide a seamless, closed-loop experience for users. Since its launch in early 2017, we have done a lot to educate developers and users about the potential capabilities of Mini Programs, including partnering with colleges to host coding classes for students and developers. Rapid adoption took off early this year, with a growing number of developers creating Mini Programs for their own companies as well as system integrators developing Mini Programs for their clients.

Benefiting from the expanding categories of Mini Programs, which include various services such as Mini Games, tools and offline services, we grew daily active users of Mini Programs to more than 200 million. Sharing in our social network facilitated user acquisition while highly popular Mini Games further accelerated adoption and engagement. Mini Programs are great for discovery and quick actions and are complementary to full-function native apps by increasing download and traffic to them.

In terms of some examples on how Mini Programs expand penetration across different representative use cases, I'll provide 4 of them. Number one, in transportation sector, our internally developed transport payment solution called Tencent smart transit QR code enabled public transport operators to achieve higher processing efficiency, reduce costs and utilize data for service planning. We have rolled out our payment solution in over 90 cities across the country. Some operators simply adopted our payment QR code while others developed their own Mini Programs with additional functionalities as well as advertising to broaden their revenue streams.

In the area of Smart Retail, Mini Programs helped merchants shorten in-store checkout time, facilitate order for home delivery and provide targeted product promotions via embedded links to Official Accounts. Many retailers find these capabilities extremely useful as they seek to digitize their businesses and engage with customers online. Our Scan-to-Buy function is increasingly adopted in shopping malls, supermarkets and convenience stores.

In the restaurant sector, preordering Mini Programs help operators increase efficiency and sales by cutting queuing time, reduce labor costs as customers switch to ordering online. They can also reward customers with integrated eLoyalty program.

Mini Programs are widely adopted in fast-food chains, cafés and casual eateries across China.

In the Mini Games sector, developers can expand user reach and acquire users via multichannels such as Weixin Game Center, search within Weixin or social referral. Given its easy-to-play and light experience, Mini Games help developers to accumulate users and traffic and monetize via advertising and virtual item sale on Android. In the second quarter, we introduced ads in Mini Games and drew enthusiastic responses from advertisers. Advertising revenue was up 5x quarter-on-quarter.

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

[James Mitchell, executive]

Thank you, Martin. And good morning and good evening to everybody. In the second quarter of 2018, our revenue grew 30% year-on-year. VAS represents 57% of our revenue, within which online games contributed 34%; and social networks, 23%. Online advertising was 19% of our total revenue, and the other segment accounted for 24% of our total revenue.

Within the other segment, where revenue was up 81% year-on-year, our payment-related businesses sustained strong growth as we rapidly expanded our offline commercial payment volume and related services and despite quarter-on-quarter reduction in interest income from restricted custodian deposits. Under PBOC's guidelines, we expect that by January next year, we'll no longer generate interest income from restricted custodian deposits, and John will discuss the details in the financial section.

Our cloud services revenue doubled year-on-year as our paying client base increased significantly. We deepened penetration in key sectors, including finance, Smart Retail and municipal services. We also invested in and formed strategic partnerships with certain systems integrators to offer customized cloud services and broaden our penetration offline.

The value-added services segment revenue was CNY 42.1 billion, up 14% year-on-year, though down 10% quarter-on-quarter. Our social network revenue was CNY 16.9 billion, up 30% year-on-year but down 7% quarter-on-quarter. Total VAS subscriptions grew 30% year-on-year to 154 million subscribers as our video subscription count more than doubled.

Our revenue grew strongly year-on-year, driven by video subscriptions and the increased monetization of music live broadcast services. However, sequentially, game-related item sales reduced sharply following the reported smartphone game revenue reduction, which offset growth in digital content revenue and resulted in the net quarter-on-quarter revenue decline.

Our online games revenue was CNY 25.2 billion. Revenue decelerated to 6% year-on-year growth and declined 12% quarter-on-quarter. Non-monetization of popular tactical tournament games in China was the main reason behind the year-on-year and quarter-on-quarter deteriorations. However, during the quarter, we grew our smartphone game DAU in China by a double-digit percentage year-on-year, expanding the foundation for our smartphone game business' long-term growth and creating future monetization opportunities. In overseas markets, our games Arena of Valor and PUBG MOBILE expanded their user bases and monetization.

In social networks, we continue to grow our mobile payment activities, leveraging our social platforms. At the end of June, we surpassed 800 million mobile payment MAUs. Our average daily transaction volume increased over 40% year-on-year, and benefiting from the expansion of use cases, our offline commercial payment volume increased 280% year on year. Commercial payment volume exceeded half of total transaction volume for the first time. In overseas markets, we prioritize use cases for Chinese outbound travelers such as duty-free shopping and tax refunds. And in Hong Kong, we launched a local wallet authorized by the HKMA.

Shifting to WeiShi, which is our aggregation platform providing mini videos conveniently to our users, both via our existing services as well as via our WeiShi-branded mobile app. During the quarter, WeiShi aggregated appealing content, including clips from our self-commissioned variety show Produce 101; and added innovative features such as artificial intelligence, face beautification tools and online photo functionality. Thanks to our content library and new features, we saw robust growth in daily mini video views, particularly on KanDian and Qzone as well as in the WeiShi-branded app itself.

We more than doubled our long-form video subscription base year-on-year to 74 million subscribers as of the end of June. We also continue to lead peers by mobile DAU and daily video views, solidifying our position as the #1 online video platform in China. Among nongame apps, Tencent Video ranks #1 in China iOS Top Grossing Chart and #2 in the global iOS Top Grossing Chart during the period. Our growth benefited from exclusive content in key verticals, including drama series, online variety shows and Chinese anime.

In drama, Legend of Fuyao, a historical romance created out of a China literature IP, generated about 14 billion video views in total and was the most popular exclusive drama series in the first half of the year. The online variety show, our self-commissioned talent program, Produce 101 achieved over 5 billion video views, a new record for an online variety show in China.

And in Chinese anime, we've built up experience producing IP-based anime series, which attracted large audience and loyal fans. And as a result, we more than doubled our anime traffic year-on-year.

For example, Land of Warriors has accumulated over 3.5 billion video views. This is the most popular of its kind since its debut in January.

On the product operations front, we're increasing the appeal of our video subscription through initiatives such as allowing users to give subscriptions to our (sic) [ their ] friends, and we're extending the distribution of our video subscriptions through cross-promotions with partners.

The smartphone games revenue was CNY 17.6 billion, up 19% year-on-year, due primarily to action games, Honour of Kings. Our revenue declined 19% quarter-on-quarter as, first, users shifted time to non-monetized tactical tournament games; second, we launched 5 out of the 7 new games late in the quarter; and third, during the pre-examination season, we prioritized user retention and engagement for several of our big existing titles. However, thanks largely to the breakout popularity of our tactical tournament games, we believe our China game -- China mobile game market share increased year-on-year and increased quarter-on-quarter in terms of daily active users and time spent.

Looking ahead, we're working on multiple fronts to reinvigorate our revenue growth, including, first, expanding overseas. Arena of Valor, a vast arena game developed by our Timi Studio, has over 13 million daily active users outside China with particular popularity in Southeast Asia and achieved over USD 200 million in user spend in the first half of the year. PUBG MOBILE, a tactical tournament game developed by our Quantum Studio, has over 14 million DAU outside China with particular popularity in Western markets as well as in India and has achieved about USD 20 million user spending per month in recent months, benefiting from seasonal passes.

Second, boosting our existing game performance and monetization. In particular, we're seeking the approvals required for monetizing tactical tournament games in order to realize the revenue potential of these games, which we believe will be substantial given the large player base and intense player activity. And we're also finding ways to deepen user activity in existing hit titles such as Honour of Kings, which remain China's top game in terms of users and revenue.

Third, launching new games in high-ARPU categories. For example, MT4, a role-playing game based on a well-known IP, was consistently ranked top 3 in iOS China Top Grossing Chart since we launched it in July. And our in-house developed RPG, Saint Seiya, is ranked top 5 in iOS China Top Grossing Chart since we launched it in August.

Moving to PC client games. Revenue was CNY 12.9 billion, down 5% year-on-year and down 8% quarter-on-quarter. The year-on-year decline reflected the ongoing trend of users shifting time to mobile games. On a quarterly basis, revenue was impacted by the same trend as well as with seasonality. However, our leading titles' performance showed resilience, supported by loyal user bases as well as eSports and other offline events.

For example, Dungeon & Fighter celebrated its 10th anniversary in June, demonstrating our ability to sustain and grow a game franchise over a decade. We engaged users by in-game marketing activities during the Labor Day holiday and an anniversary celebration gala offline, driving up revenue and paying user accounts.

League of Legends held its mid-season invitational eSports event in May, in which the Chinese team RNG won, benefiting DAUs in China. League of Legends DAUs were up quarter-on-quarter in China and flat quarter-on-quarter globally despite adverse season -- summer seasonality.

We look forward to publishing several titles in coming months and quarters. For example, we've accumulated over 10 million preregistrations in China for Fortnite, the tactical tournament game developed by our investee, Epic Games.

Moving on to our online advertising business. Revenue in the second quarter was CNY 14.1 billion, up 39% year-on-year and up 32% quarter-on-quarter. Our media advertising revenue was CNY 4.7 billion, up 16% year-on-year and up 43% quarter-on-quarter.

Video advertising revenue continues to grow as we generated more sponsorship revenue from popular programs. When we sell commission content, we can tie it to the most appropriate advertisers and develop attractive ad formats early in the production process.

Our news advertising revenue declined by a high single-digit percentage year-on-year from the high base point last year. But following the completion of our ad system revamp, we resumed news feed ad placement within our news services in the second quarter, which, along with positive seasonality, contributed to a strong quarter-on-quarter rebound.

Our social and others advertising revenue was CNY 9.4 billion, up 55% year-on-year mainly due to 3 factors. First, in Weixin, we added a second feed ad per user in Moments as well as new inventories in Mini Programs. Second, we saw robust growth in impressions in and advertiser demand for our Mobile Ad Network. And third, we generated more news feed traffic in QQ KanDian, driving up impressions volume. Sequentially, social and others advertising revenue grew 27% quarter-on-quarter, benefiting from positive seasonality as well as the factors above.

And with that, I'll pass on to John to go through the financials.

[Shek Hon Lo, executive]

Thank you, James. Hello, everyone. For the second quarter of 2018, our total revenue was CNY 73.7 billion, up 30% year-on-year or stable quarter-on-quarter.

Gross profit was CNY 34.4 billion, up 22% year-on-year or down 7% quarter-on-quarter. Net other gains was CNY 2.5 billion for the second quarter. On a year-on-year basis, it mainly reflected decline in net gains from investee companies and high impairment provision for certain investments. These 2 items, however, are all non-GAAP adjustments.

Share of profit of associates and joint venture was CNY 1.5 billion in the quarter, with a share of losses of CNY 319 million last quarter. The Q-on-Q change was mainly due to increase in profit contribution from Epic due to the success of Fortnite in overseas market. On a non-GAAP basis, share of profit of associates and joint venture was CNY 2.8 billion for the second quarter.

Income tax expense was approximately CNY 3.6 billion, down 9% year-on-year or down 37% quarter-on-quarter, primarily due to lower withholding tax. The effective tax rate for the quarter was 16.2%. Net profit attributable to shareholders was CNY 17.9 billion, down 2% year-on-year or down 23% quarter-on-quarter.

I will walk you through our non-GAAP financial numbers. For the second quarter and after adjustments to non-GAAP, operating profit for the quarter was CNY 22.3 billion, up 11% year-on-year or down 12% quarter-on-quarter. Operating margin was 30.2%, down 2 point -- 5.2 percentage points year-on-year or down 4.2 percentage points quarter-on-quarter.

Net profit to shareholders was CNY 19.7 billion, up 20% year-on-year or up 8% quarter-on-quarter. Net margin was 27.8%, down 1.3 percentage points year-on-year or up 1.8 percentage points quarter-on-quarter.

Let's turn to segment gross margin. Gross margin for Value Added Services was 59%, down 1.6 percentage points year-on-year or 4.3 percentage points quarter-on-quarter. The decreases mainly reflected the revenue mix shift from games to lower-margin digital content subscriptions and live broadcast services as well as the rising content costs of such businesses.

Gross margin for online advertising was 37.4%, stable on year-on-year basis or up 6.2 percentage points quarter-on-quarter. The quarter-on-quarter increase was mainly driven by increased advertising revenue due to positive seasonality.

Gross margin for others was 24.9%, up 2.5 percentage points year-on-year or stable quarter-on-quarter. The year-on-year increase was mainly due to growth in revenues from micro loan business, interest income related to restricted custodian deposits and fees charge from credit card repayment. PBOC has gradually stepped up the centralized deposit ratio requirement for third-party online payment services for providers such as ourselves, where we are required to move restricted custodian deposits to noninterest-bearing accounts. The ratio was increased from 32% in March to 42% for the second quarter and finally, up to 100% by January 2019.

As such, interest income recognized under either segment has dropped to low-teens percentage of others segment revenue for the second quarter and will continue to impact on segment revenues and margins. We are seeking to mitigate the impact through various monetization initiatives in our payment and related businesses. These included growing our Internet finance revenue such as micro loans and wealth management products, which carry higher margins than payment business; as well as managing marketing expenses.

Moving on to operating expenses. Selling and marketing expenses were CNY 6.4 billion, up 74% year-on-year or 14% quarter-on-quarter. The year-on-year increase mainly reflected greater marketing spending in our products and platforms such as online games, online media, payment-related services and mobile utilities. The sequential increase was driven by seasonally more advertising and promotional activities in the second quarter. As a percentage of revenue, selling and marketing expenses increased to 8.6% for the second quarter.

G&A expenses excluding R&D were CNY 4.1 billion, up 5% year-on-year or down 7% quarter-on-quarter. Under G&A, R&D expenses were CNY 5.7 billion, up 35% year-on-year or 14% quarter-on-quarter. Both year-on-year and quarter-on-quarter increases of G&A expense were mainly due to greater R&D expenses and staff costs. As a percentage of revenue, total G&A was 13.4% and R&D was 7.8%.

At the end of second quarter, we had over 48,600 employees. The year-on-year increase of 20% was mainly due to our expanded business scope; in particular, online games and cloud businesses.

Let's go through margin ratios for the second quarter. Gross margin was 46.8%, down 3.2 percentage points year-on-year or 3.6 percentage points quarter-on-quarter, mainly reflecting the revenue mix changes among segments and reduced gross margin of VAS, as mentioned previously.

Non-GAAP operating margin was 30.2%, down 5.2 percentage points year-on-year or 4.2 percentage points quarter-on-quarter due to lower gross margin and higher marketing expense. Non-GAAP net margin was 27.8%, down 1.3 percentage points year-on-year or up 1.8 percentage points sequentially, which fell, to a lesser extent, due to the margin pickup from share of profit of associates and income tax expense, as mentioned earlier.

Let me share some key financial metrics with you before wrapping up this presentation. For the second quarter, total CapEx was CNY 7.1 billion, up 135% year-on-year or 12% quarter-on-quarter. Operating CapEx was CNY 6.6 billion, increased by 183% year-on-year as we reserved more servers to offline business growth. Nonoperating CapEx was CNY 495 million.

Free cash flow was CNY 15.4 billion, down 12% year-on-year or up 18% quarter-on-quarter. At the end of the quarter, our net debt position was CNY 35.3 billion compared to net debt of CNY 14.5 billion last quarter. We turned to net debt position in 2018 mainly due to increased strategic M&A investments amounting to USD 7 billion in the first quarter. We have moderated the pace of M&A activities in the second quarter, reducing to around USD 3 billion net payments. We will continue to review and evaluate the needs in monetizing our investments such as Mobike and [ early mile ] which we disclosed recently. The fair value of listed investee companies, excluding subsidiaries, of course, were approximately CNY 248 billion or approximately USD 36.2 billion as of quarter end, up from CNY 146 billion a year ago.

Thank you. We shall now open the floor for questions.

[Jane Yip, executive]

[Operator Instructions] Shall we invite the first question now?

[Operator]

[Operator Instructions] The first question comes from the line of Eddie Leung from Bank of America Merrill Lynch.

[Eddie Leung, analyst]

I guess the first one is about the current situation of the mobile game approval process in China. Just wondered if you guys could help us to understand if the current situation has affected you. And what are some of the measures that we are implementing to handle the situation?

And then, secondly, a quick question about your video advertising business. I remember, last quarter, there was a very strong year-on-year growth, but it seems like we saw some deceleration in second quarter even on the back of Produce 101. So just curious if the so-called cannibalization from the subscription pieces is a reason. And would this be the norm going forward? Namely, we will be seeing strong subscription growth but perhaps a slowdown in video advertising?

[Chi Ping Lau, executive]

Okay, Eddie. Thank you very much for your questions. Let me first address your first question regarding mobile game and broadly -- most broadly, game approval process. Basically, what's happening now is that there is a temporary suspension on the GAPP's monetization approval, so that games without that license cannot really officially start monetization. And that's mainly because of a restructuring of the officiating bodies that is going at the senior government level. So as a matter of fact, a lot of games have not been approved. Now what's happening is that for the games that have been approved before, they can still be launched and be monetized. And as you can see, we do have a lot of games in the pipeline which have been approved for monetization, so we have been launching games with monetization. And right now, at least 15 games within our game portfolio have been approved for normal monetization. Now with respect to new games, the administration is also aware of the fact that because of the restructuring, it's now affecting the industry as a whole. So the GAPP has set up a green approval process, which means that if you can go through that green channel, then you can actually have 1-month monetization testing, and that's acted as a relief for the entire industry. Now unfortunately, given the fact that our PUBG MOBILE games have already been launched and has reached a very significant size, we do actually need to go through the official GAPP monetization approval process, which, at this point in time, we don't have visibility on when exactly it will restart yet. But we are also aware of the fact that GAPP is constructive in giving out this temporary monetization period, which we hope is an indication that the official approval process will start again. Now we'll be working very diligently to work with the government in order to get the approval of PUBG MOBILE when the monetization formal approval process restarts. So that's really the situation at this point in time. We do believe it's not a matter of whether these games will be approved for monetization. It's a matter of when exactly we can actually do that.

[James Mitchell, executive]

Eddie, on your second question about video advertising revenue decelerating, yes, your inference is correct actually. After a long period where our -- within our media revenue, our news-related revenue was extremely weak, and our video ad revenue was extremely strong. This quarter, we saw a little bit of reconvergence on both sides. So our video ad revenue decelerated for a few reasons. One is that we took the opportunity this quarter to really work on reducing the discounts offered to ad agencies, and that actually had some meaningful impact, which helped our video advertising gross margin 5 percentage points but didn't help our video advertising revenue. A second is some of the big content you alluded to such as Produce 101, while there's certainly advertising sponsorship around it, we also took the opportunity to reduce that popular content to drive our subscription revenue or our [ hosting ] activities, which we're quite proud of because, historically, as you know, variety shows and so forth don't really lend themselves to the subscription business model, but we think we've made some progress on that front, which is important for the future. Big picture and stepping back, we believe that our overall video advertising revenue grew probably similar to the industry growth rate in the second quarter, but our video subscription revenue, we knew, grew substantially faster than the industry at over 100% year-on-year. And so therefore, in aggregate, we believe that our video platform grew revenue faster than the video industry year-on-year.

[Chi Ping Lau, executive]

One last point I want to add is the Produce 101 and content such as Fuyao have exceeded really the initial expectation, and a lot of the advertising we sold was actually presold. So I would say some of these content we under-monetized compared to the actual result that we achieved. But for Produce 101, that actually set up for much better monetization for next season.

[Operator]

Next question comes from the line of Jin Yoon from New Street Research.

[Jin-Kyu Yoon, analyst]

I think on the gaming side -- or overall, deferred revenues were down about 10% sequentially. If you could just kind of help us segregate that between what gaming and PC -- deferred revenues in PC gaming -- or overall gaming in China looks like versus memberships and international business.

And then my second question is, James, I think you mentioned some growth prospects for news feed propelling. Can you just give us some operating metrics beyond that, perhaps MAU, DAUs or even ad loads?

[Shek Hon Lo, executive]

In terms of deferred revenues, you are right that there are many moving parts inside that, including the prepaid advertising, prepaid money subscriptions, the business cooperation agreement with monthly amortization, of course, and prepaid tokens and tax. Deferred revenue usually softens after peak season for games, especially for Q2 and Q4. For example, in quarter 4 2017, the deferred revenue dropped by roughly 3.5%. And out of the 9.5% drop, I would say that about 3.5% more seasonal in nature as evidenced in the drop of about the same percentage in quarter 4 2017. For the remaining, about 6%, included about CNY 600 million quarterly amortization for business cooperation agreement, which accounted for roughly 1.5%. The remainder, say 4.5%, was attributable to games and others. And for games, PC would have a much bigger impact than mobile. Having said that, the year-on-year deferred revenue is stable.

[Chi Ping Lau, executive]

And our media feeds in our prepared remarks, we did talk about our overall strategy. If you look at the reading activities, right, and you're within Weixin, which you have an entire ecosystem based on Official Accounts, and that's something that we for now put aside because it is a very big ecosystem, and it generates billions of page views every day. And it has been very solid in terms of its overall performance in terms of time spent. But in addition to that, we have been creating media feed products within each one of our large DAU products. So, for example, within QQ, it's QQ KanDian. Within QQ Browser, there's the news feed. These are for now the 2 largest news feed products for us. And within the media feeds, we try to put in different media formats, including news feed, including short videos and over time, mini videos. For now, the metrics that we look at is that usually, what happens with these media feeds integrated into our large DAU products is that they tend to have a pretty large DAU. But usually, the users would read fewer number of PVs on average and number of VVs on average. Now we have given you an aggregate number, which is for the 2 largest product, KanDian and QQ Browser. The totally daily page views through these media feeds is up 55% year-on-year, and the total number of short videos view is up more than 3x year-on-year. And in terms of the mini video, which is now curated by WeiShi, it's also distributed through these media feeds. That's the first and most advanced integration is actually through QQ KanDian, and we can see there's a very strong traction in terms of the growth of the viewership on mini video in QQ KanDian. And over time, we'll propagate that mini video feeds to other media feeds in our products, including QQ Browser, video as well as Weixin.

[Operator]

Next question comes from Gregory Zhao from Barclays.

[Gregory Zhao, analyst]

The first question is about your advertising. So Tencent expand more ad inventories during the quarter. So can you help us understand how would that affect the pricing of your advertising going forward. At the same time, we also noted some other short video, social and news apps such as [ DoWe ], Weibo, [ Totao ], they also substantially increased your ad inventory. So can you help us understand the potential impact to the overall online ad industry price trend?

And also very quick follow-up on gaming side. So the recent suspension of your Monster Hunter, is that a one-off issue of gaming content or it's also signal of more restriction from the government?

[Chi Ping Lau, executive]

Well, in terms of new advertising, I would say our advertising inventories, we have been pretty much very restrained, self-restrained in terms of putting out inventories. I think if you look at our social product, Weixin in the Moment, we now have just expanded our inventory to 2 advertising per day on the maximum. And that's a fraction of what international competitive products or comparable products are putting out. And even with our -- within our new media feeds business, our ad rate -- ad inventory is actually only a fraction of our comparables. So I think for our product, the advertising business, it's still very much inventory constrained. And the reason is that, of course, is we try to build our advertising business on a consistent basis. And with that, we want to make sure that we make the most and optimal trade-off between user experience and also pricing and positioning of the advertising. And we also try to make sure that the quality of the advertisers are high. So as you can see, we don't really have medical advertisers. We don't really have P2P financial advertisers, and we also try to create this tightness, so that we can help the advertisers to put up better quality advertising. So I think our entire advertising business is actually growing according to our own pace, and it's less affected by what's happening in the overall performance ads industry. That was the case when there was search advertising, when there was all kinds of different advertising. And that's still the case at this point in time.

Now in terms of Monster Hunter, I would say it is really a one-off event. The key reason is that we have gotten the approval actually to launch Monster Hunter with monetization. And what happened was the content eventually delivered by the developer was actually not -- did not completely comply with the regulatory requirement. And as a result, we have to suspend the sales of the content, and we need to adjust the content alongside with the developer in order to prepare it for approval in the future. We -- through this process, we have established a tighter communication with the relevant government officials and regulatory body. And we hope this is something that will improve our process going forward.

[Operator]

Next question comes from Natalie Wu from CICC.

[Yue Wu, analyst]

I have 2 here. Firstly, I saw very decent growth for the active user of your League of Legends. Just wondering what's the major constraints for the growth of this revenue. Is it mainly related with those rare skin reserves in that game? If yes, so when should we expect to see a meaningful improvement for that?

And secondly, can you give us some color on the current contribution for commercial payment and interest income in other revenues item? And should we assume the interest income item to finally go to 0 if the centralized deposit ratio goes up to 100%?

[James Mitchell, executive]

So with that, I think your first question was around League of Legends, and we've seen some, as we mentioned in the prepared remarks, we've seen a nice upsurge in interest in the last couple of months for League of Legends, especially in China, which may reflect a degree of patriotism around it, a Chinese team winning a global event in the eSports. So that's exciting for us.

On the monetization side, outside China, the game's revenue was actually fractionally up year-on-year last quarter. But inside China, the game's revenue has been a little bit weaker since the fourth quarter of 2017, and that reflects the phenomenon you mentioned seeking to replenish our rare skin reserves and so forth. In terms of how quickly we will reverse that phenomenon, obviously, it's a work in progress. Obviously, the comps get a little bit easier toward the end of this year. But I would also say that as we look at the success of other free-to-play PC games globally such as Fortnite, that we've really been positively surprised by the willingness of players of these free-to-play games to participate in voluntary monthly subscriptions. I know it sounds a little bit contradiction in terms of someone would choose to subscribe to something for which they do need to subscribe. If you put the right content and the right concepts into the season passes, then actually, that's very good take up for the season passes in certain environments. So that's a positive sign as well.

[Chi Ping Lau, executive]

In terms of the deposit interest, right now, in this current quarter, it accounts for low teens percentage of our others revenue. And the way to think about it is that we have already had 42% of the deposit taken away. The interest is already taken away, and we have another 58% to go. And the schedule as announced by PBOC is that it will be pretty much evenly distributed for the next 6 months for that 58%. So by January of 2019, the entire deposit will be taken away. Now as John has talked about in the prepared remarks, we would try to mitigate some of these impacts by more efficiently managing some of the marketing costs that we have, because we are spending actually a lot of money on marketing our payment platform. And as you can see, there's a very strong growth in our payment platform, especially with respect to off-line commercial transactions partly because of the strength of the platform itself, but also partly because of the marketing program. And given the loss of the interest that we'll try to optimize the marketing plan and try to pick up the ones that are more efficient. And at the same time, we feel that we can also, over time, deliver more financial services to some of the merchants that are connected by our payment platform. As you can see from the prepared remarks, our commercial transactions, especially on the off-line side, has increased very significantly. And that means our payment platform is now connecting to millions of off-line merchants. And we believe that these are very, very important assets for us. Over time, we can deliver transaction-based services to them, including financial transactions as well as advertising transactions. So those are things that we'll be doing over time. Now the way I look at this loss of interest income is that it's, of course, very painful event, right? And we're halfway through. We'll try to mitigate part of the other half. And once it's all done, then basically, it becomes a onetime event, and it will not affect the trend line of the growth of our payment business.

[Operator]

Next question comes from Alicia Yap from Citigroup.

[Alicis a Yap, analyst]

I have a couple of questions. The first one, wanted to look at when we look at the various initiatives that management put together on the prepared remarks to revise the growth for the gaming business, for short term such as like 3Q, which initiative will be the biggest driver? Will that be the enhancing monetizations of existing games such as Honours of King (sic) [ Honour of Kings ] being the biggest driver? Or would that be the new revenue contribution from your newly launched games?

And if you look back 6 months ago, do you think that the company or management will still go ahead to launch the 2 PUBG MOBILE games knowing that monetization may come later? Or will you actually consider waiting to launch for PUBG until the later stage?

For second question, on the advertising opportunity related to Mini Games, could you help us -- sorry, Mini Programs. Could help us understand a bit among the different industry vertical, is that fair to say most of the incremental advertising revenue would come from the traditional retail and the local services brands and merchants? If not, any major vertical that you could highlight? And could you help us frame the market size for that?

[James Mitchell, executive]

Perhaps I'll try to tackle the first question, and I'll pass it on to Martin for the second and third. So I think the first question was around which of the initiatives that we're now undertaking in our mobile game business to reinvigorate growth will bear fruit in the third quarter end. And I think that sometimes, these initiatives take some period of time, and period of time could be months, could be quarters to bear fruit. But in general, we're optimistic that they will bear fruit as we move into next year. Just drilling down one level. I'd also having -- had some understanding of the concern investors have about the second quarter results, I think that one aspect that may not have been asked, but I'm sure that it might is really during the first half of this year for whatever reason we didn't release as many successful high ARPPU games as we had in previous periods, and that's why I called out that in July and August, we would release a number of high ARPPU games in categories like role-playing games, card games, and those games, at least initially appears to be off to a rather healthy start. So, as well as the much-debated monetization tactical tournament games issue, there is also some short-term volatility in terms of cadence of the balance between higher ARPPU and lower ARPPU games. And as Martin said, we have over a dozen mobile games already secured monetization approval. Some of those will be in these higher ARPPU categories. And with that, I'll pass to Martin.

[Chi Ping Lau, executive]

Yes. With respect to the game business, right, I would just say my observation is that the gaming fundamental is actually as strong as it has been because if you look at our DAU in China, it has a very solid growth compared to last year. We have really become the category leader in tactical tournament, which 6 months ago, it was not very apparent. It was a very big segment with another game, which has taken the lead. But within the past 6 months, we have taken a complete lead over that genre, and it doesn't really stop in China. If you look around the world, we have also expanded our presence outside of China. Part of it is through Epic, which has become the biggest category winner in this tactical tournament genre in the Western world. And, at the same time, if you look at our own developed games, both AOV and PUBG MOBILE has achieved more than 15 million DAU outside of China, which is a very significant achievement. It also marks a significant step for us to expand our gaming business outside of China. So all these operating metrics are very strong. The only problem that we have is actually for one of our biggest game, PUBG MOBILE, is not monetizing. And I think this is something which is a little bit out of control. But over time, I think we will be able to solve it.

Now with respect to Mini Programs, I think it's really an overall ecosystem in which we are trying to connect our users with many different types of off-line activities. And a lot of these are transaction based. A lot of these would not even get the chance of getting the online engagement if there's no Mini Program because if you really need to download an app, most of the users will be gone. But because of the availability of Mini Programs, many of these connections are made. Yes, a lot of their connection is actually between off-line and online. And a lot of it is due to the retail industry. But I think there's also a lot other interactions too, right? For example, through retail, we are also going through touch upon brands. We find that a lot of brands are looking at Mini Program as a way for them to engage with their users. And even though they are not directly having a retail relationship in-store, the brands want to touch a point, their customers. They want to understand who are their customers, and through Mini Program, in the past they were not able to do it, now they are able to do it. So I think Mini Programs really help, one, all kinds of different services to reach their users online; and two is whenever they have a point of contact, be it off-line or online, they can have an additional transaction or additional action that can be taken by the users; and thirdly, Mini Program also allowed a lot of social sharing of different kind of interaction. So it allows word-of-mouth to be spread for different services and brands.

[Operator]

Next question comes from Wendy Huang from Macquarie.

[Wendy Huang, analyst]

My first question is about the earnings growth outlook. So this quarter, the revenue growth jumped to only a 30%, probably the lowest in past 3 years and yet operating profit growth was only 20%. So you mentioned a lot about the launching of the high ARPPU games and Mini Program to be a structure driver in the future. I just wonder when should we expect those things to really bring the earnings growth back to above 30% level? Or would the temporary hiccup in the game business and with some macro headwinds where you control the cost such as the G&A to ensure better earnings growth?

And second, can you give us some clarification around the Fortnite. So whether the Fortnite PC has already obtained the monetization approval. And also what's the progress of the Fortnite mobile development? If the Fortnite mobile is to be launched in the future, does it requires separate approval from PC version or not?

[Chi Ping Lau, executive]

Okay. Well, I think -- so from a revenue growth perspective, the gaming sector is one key area of weakness. And as we have said, a big part of it is because of our biggest game is not monetize-able. And I think the growth will return when it is monetize-able. So it's an event that we're working very hard toward. And, of course, in the meantime, there are a lot of things that we will be doing in order to try to mitigate the problem. But I think the biggest issue is really trying to monetize our biggest game. And, at the same time, when we talk about higher ARPPU games, and when we talk about expanding our presence outside of China and trying to monetize better there. I think there's a number of different measures that we can try to grow our business as well.

In terms of I would say -- what's the next question? Fortnite, right? For Fortnite, the current situation is that the PC version of Fortnite has already received the Ministry of Culture and Tourism approval. So we can launch the game. We are now -- right now applying for the green channel approval for monetization for 1 month with GAPP before any game can be approved for formal monetization. That's still ongoing. And if and when we get that approval then we can start monetizing. So far, I think when we look at Fortnite's preregistration and also in the beta testing, the rate of people's response is actually pretty good. Now with respect to the mobile game, we do need to have a separate approval process for the mobile game, which will follow after we have launched the PC version of Fortnite.

[James Mitchell, executive]

So just to supplement, Martin, on the first question and specifically around the relatively slower earnings growth, as Martin had mentioned earlier, there's a couple of substantial factors which are temporarily impacting our earnings growth, which, one could try to quantify, and one is the nonmonetization of the tactical tournament games, which we believe could be very substantial based on what we already see internationally and based on industry logic. And then the second one is the fact that we're halfway through this process of losing the interest income on the deposits, which -- again we're halfway through that process. We think we'll find some offsets as we work through the second half of that process, and that's a finite onetime process.

[Operator]

Next questions come from Han Joon Kim from Deutsche Bank.

[Hanjoon Kim, analyst]

I just wanted to differentiate the publishing of games in China. So what goes on to e-games? And what goes on to kind of direct publishing into china? And how we should think about the evolution of -- or growth of WeGame going forward?

And the second question is I think we've introduced the Battle Pass to our PUBG global version. And just kind of wanted to get your impression on how you see the evolution adoption of that Battle Pass relative to Fortnite success. My understanding is the ranking is a bit lower, so the impression is that the paying adoption rate for PUBG MOBILE is lower. So just trying to understand the relativity of that context.

[James Mitchell, executive]

Yes. So let me try to answer both of those. So first with regard to what we would publish versus what we sort of platform through the WeGame platform, I think the -- simplistically, in the past one could have said that for a game of a massively multiplayer characteristics, then our first instinct would be to try to publish it ourselves because there's a great deal of local expertise there required, local optimization that's required and local customization. That means simply copy/pasting, translating and tweaking it is not sufficient to make the game be all that it can be in China. When we look back I think great part of the success of products like Dungeon & Fighter, which is multiplayer; League of Legends, which is multiplayer; CrossFire, which is multiplayer; all imported games, all games that we publish ourselves in China have gone on to great success due to the fact that they're great product but also to the fact that we've taken on half the publishing. So that's a typical classic, you know, direct publishing experience. Now the games, which are more single player in nature, perhaps more narratively driven in nature then historically, they might make more sense to put on a Steam-like platform or on a WeGame platform, and that's initially the pattern that the first successful games on WeGame were products like Don't Starve, which were relatively simpler in nature, required relatively less local optimization. Monster Hunter, while it is a really interesting hybrid in that it does have a relatively strong narrative but, at the same time, it's a game that people generally play on a cooperative basis. So it's a cooperative player versus environmental player versus gigantic fire-breathing monster experience. And as such, the interest that our users have in it, was extremely encouraging for the future, it's just unfortunate that now we need to tweak the product a little more, so we can provide it to our users. So that in terms of the WeGame versus direct publishing parts.

In terms of the Battle Pass monetization for PUBG MOBILE, we're pretty happy. It's early days. I would say that PUBG MOBILE as the name suggests is a mobile game versus Fortnite is console, PC and mobile. And my guess is because console -- because Fortnite is console plus PC, it's tapping into some younger users who historically might have had a habit of buying X number of packaged software per year. And now, they're willing to redirect some of that money into the monthly subscriptions service versus -- because PUBG MOBILE is only mobile and the users are generally comparing it with Clash of Clans or Candy Crush where they don't historically have a habit of buying a dozen packaged software each year. So in that sense, I think we will see -- we're seeing, and we should expect to see a slower build of the monthly pass Battle Pass revenue in a product like PUBG versus the really excellent, outstanding process -- progress that Epic have made with Fortnite or for that matter, the Electronic Arts have made with the FIFA Games.

[Jane Yip, executive]

And due to the time constraint we will take the last 3 question from the floor.

[Operator]

The last 3 questions comes from the line of Karen Chan from Jefferies.

[Karen Chan, analyst]

So my first question is how much of a pipeline buffer do we have until we get more visibility on resumption of new license approval? Does the 15 games in the pipeline mean that we have already secured license? Does that include recent launch titles like MT4? In other words, will that impact any new higher ARPPU mobile game title launch in fourth quarter?

And also on the PC front, you mentioned that we are in the process of applying for green channel for 1-month monetization testing on PC Fortnite. Just wondering earlier, do we expect some sort of monetization contribution in fourth quarter?

[James Mitchell, executive]

Yes. I think -- we gave a figure for the number of mobile games in our pipeline that have already secured approval. And, obviously, that figure would include a mix of different kinds of games. And so I suppose if you wanted to look at it from a buffer perspective, then one can. I think that in terms of Fortnite PC, the green channel, the point we were alluding to is the approval process of Fortnite PC is different from and to some extent, more in line with historic norms than the approval process for the PUBG games. And so therefore, while it's hard to forecast exact approval process, given some of the changes in the regulatory environment, at the same time we think that's an approval process that should be more consistent with historical norms, particularly as Martin said, since we have the Ministry of Culture approval already. And historically, the time lag between Ministry of Culture and GAPP approval is relatively shorter.

[Operator]

Next question comes from Grace Chen from Morgan Stanley.

[Grace Chen, analyst]

My question, let me switch the gear to your cloud business, which has been growing very fast. In the press release, you talk about Tencent will continue to grow the cloud business through organic growth as well as collaboration investment opportunities. Can you elaborate about your plan for collaboration, especially we've been seeing some news about your collaboration with some international players such as Google.

[Chi Ping Lau, executive]

Yes, in terms of the cloud business, it has been growing very fast. And when we talk about the collaboration, we're more talking about building an ecosystem of system integrators as well as developers who have specific expertise, so that they can develop using our cloud solution. So as you can see in some of the announcements, we actually have invested in a number of different system integrators within different vertical industries. So that when they design in their solution for their customers, they can actually leverage Tencent Cloud, and they can convert some of their existing customers from using packaged software into a SaaS solution and then move them on to Tencent Cloud. So that's the cooperation that we're talking about. And I think overall, it has been going quite smoothly. Now, of course, with some international partners, there also exist such opportunities, right? There are companies who have customers who need exposure to China. And we could provide a solution that can help them. So in those cases, we will also collaborate with the international partners.

[Operator]

The last questions comes from John Choi from Daiwa Capital Markets.

[John Choi, analyst]

I just have a quick question on your PUBG MOBILE. Assuming the approval goes through, do you guys have any sense like how big this monetization opportunity could be given that I think someone asked about Battle Pass and other initiatives. Overseas market has been falling a bit short. So are we quite confident that this PUBG if the monetization goes through, that it will kind of meet internal expectation?

And secondly, on the PC game growth, I know that we had a great year last year. But you're clearly seeing some slowdown for the remaining part of the year. And as we go into 2019, with a new WeGame platform, what kind of growth should we be expecting?

[James Mitchell, executive]

So, John, in terms of your first question on the PUBG MOBILE monetization, we're pretty optimistic. If we're permitted to monetize then we'd achieve healthy monetization. That optimism is founded on first, the very large DAU base and the very high engagement per DAU; secondly, the intense sort of competition, but also cooperation within the game, which historically is a good leading indicator of monetization; and thirdly, the global experience of the games such as PUBG itself but also of Fortnite which, as you know, we're a substantial shareholder via Epic. I didn't quite understand your comment about PUBG MOBILE international revenue underperforming. We're actually quite pleased with the early ramp. And given the fact that it's very unusual for us to monetize a game first outside China, this is sort of unprecedented in our history. And you can see that it is a top 50 game by revenue ranking in many key markets, including the United States and a top 2 or 3 game by revenue ranking in some big markets in big, emerging markets, including India. So overall, we're pretty happy with PUBG MOBILE progress outside China. We think we could monetize inside China then we would do so to a decent level. And then sorry, your second question was around the...

[Chi Ping Lau, executive]

PC game.

[James Mitchell, executive]

The PC game revenue growth. I think with mobile game, we can point very clearly to certain specific headwinds that we believe can be overcome with time. And therefore, we believe that 19% sequential deceleration in mobile game revenue should not be representative of the long-term forward trend for our mobile game business. I think for PC game business, that is a fundamentally more mature industry and, therefore, we should be relatively conservative in our expectations in 2019 and beyond. But what's interesting is if you look at results from other game companies, if you look at commentary from Nvidia, then the PC game industry globally is actually not a sunset industry at all. It continues to gradually expand, and I think the difference between China and the rest of the world is that in China, the innovation in games is very much focused on mobile games versus the rest of the world. There continues to be a decent amount of innovation around console and PC and that innovation is ultimately what drives the game industry revenue growth year-to-year even more than macro trends or installed base. And so the fact that WeGame platform is bringing some of these innovative products to China, the fact that consumers are willing to pay CNY 200, CNY 300 up-front for these innovative products, I think speaks well for a stable rather than permanently declining PC game industry in the long, long term.

[Jane Yip, executive]

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

[Operator]

That does conclude our conference for today. Thank you for participating in Tencent Holdings Limited 2018 Second Quarter and Interim Results Conference Call. You may all disconnect now.