Outperform (0700.HK) (Maintained) Games Recover; Advertising Slows Down and to B Business Surges

Home , Arena of Valor, Tencent Music

证券研究报告 COMPANY RESEARCH Tencent Holdings Ltd HK Stock Outperform (0700.HK) (Maintained) Games recover; Advertising slows down and To B business surges. August 16, 2019 TMT

Key Data Key Financial Indicators FY FY 2018A FY 2019E FY 2020E FY 2021E August 15, 2019 Revenue (Mn/RMB) 312,694 380,907 474,413 576,845 Closing Price（HKD） 330.4 YoY (%) 31.5% 21.8% 24.5% 21.6% Total Shares (100Mn/RMB) 95.55 Non-GAAP Net Profit (Mn/RMB) 77,469 93,980 112,028 135,483 Market Cap (100Mn/RMB) 31,570 YoY (%) 19.0% 21.3% 19.2% 20.9% Gross Margin (%) 45.5% 44.1% 43.4% 42.5%

Net Assets (100Mn/RMB) 4,210 Non-GAAP Net Profit Margin (%) 24.8% 24.7% 23.6% 23.5% Total Assets (100Mn /RMB) 8,169 ROE (%) 28.9% 21.4% 18.5% 17.8% EPS (RMB) 8.43 9.87 11.77 14.23 BVPS(RMB) 40.83 OCFPS (RMB) 11.18 14.90 17.48 20.29 Highlights Analyst Advertising business slightly lower than expected, Non-GAAP net profit was basically in line with ZHANG Yidong expectations. The company's total revenue of FY2019Q2 was 88.8 billion yuan, a yoy of 21%, [email protected] which was 4.67% lower than our expectation. In addition, the net income from investment- SFC：BIS749 related projects and the profit of joint ventures increased significantly in Q2, leading to 35% SAC：S0190510110012 increase of net profit to 2.41 billion, while under the Non-GAAP standard, the Profit attributable to equity holders of the Company increased yoy 19% to 23.525 billion, basically in line with our Contact expectations. The recovery of the mobile game business met our expectations and PC game business not as Venki LI good as expectation. Q2 company's game revenue was 33.9 billion yuan, yoy increase of 11.15%, [email protected] slightly lower than our expected (13.5%). Ten new mobile games were promoted, resulting in SAC：S0190118090169 income (including extraction) reaching RMB 22.2 billion, yoy increase of 26.1%, in line with expectations (25%). In PC games, the improvement of user experience of DNF contributed to the lower commercialization, making revenue decrease 9% yoy to $11.7 billion, lower than our expectation. We believe that the FY2019 H2 mobile game will keep strong tendency, and the growth rate is expected to exceed 30%. It is also expected that the PC game will recover in the second half year due to the deferral revenue of the League of Legends. Excluding interest income, FinTech and Business Services grew at a high rate. Revenue from

FinTech and Business Services increased by 37.3% yoy to RMB 22.9 billion. The proportion of revenue increased by 4 percentage points to 25.7%. Excluding the interest income from reserves, the revenue of this business increased rapidly by 57% yoy, which was basically in line with expectations. Reduced demand of advertisers and increased advertising inventory in the industry led to pressure on online advertising revenue so that we lower forecasts for the second half year. FY2019 Q2, online advertising revenue increased by only 16% year-on-year to 16.4 billion yuan. Among them, social advertising revenue was 12 billion, with a yoy growth rate of less than 30%. Media advertising revenue declined to 4.4 billion yuan, year-on-year decline of 7%, worse than expected because of 1) high revenue due to last year's World Cup 2) Reduced demand of advertisers 3) Deferral of TV play .It is expected that media advertising will continue to be under pressure in the second half year, but we are optimistic about the accelerated turned-to-revenue ability of WeChat ads (including friends circle + official accounts + mini programs). Because of the advertising inventory release leading high ROI, we expect FY2019H2 social advertising growth rate to be nearly 30%. Investment proposal: adjust the target price to HK $407.4 and maintain " Outperform". We adjusted revenue from 397.5 billion / 505.8 billion to 380.9 billion /4.7448 billion in FY2019- 2020 and adjusted Non-GAAP Net Profit from 94.7 billion / 119.8 billion to 93.9 billion /112 billion in FY2019-2020. Based on the DCF model, we adjusted the target price to HK $407.4 (original target price: HK $421.3), corresponding to 35x/30x PE of FY2019/2020 under Non- GAAP standard. Maintain " Outperform " rating.

Potential risks: Policy regulatory risk; slower growth of game business; less than expected advertising business; decline in ROE, gross profit margin, etc.; organizational structure adjustment does not meet expectations; risk of decline in the length of use of Tencent product users This English translation of the original Chinese version <腾讯控股（0000.HK）_游戏恢复景气，广告放缓，To B 增长强劲_20190815> issued by Industrial Securities on 2019.08.15. is for information purpose only. In case of a discrepancy, the Chinese original will prevail.

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证券研究报告 COMPANY RESEARCH Report Text

Event: Tencent Holdings (0700.HK) released its Q2 FY2019 and full-year performance announcement on August 14: the company's total Q2 revenue in FY2019 was 88.821 billion yuan (the same below), an increase of only 21% over the same period last year and a month-on-month growth rate of 4%. About 4.67% lower than we expected and 5% lower than Bloomberg expectation. The expense rates increased month-on-month, mainly because of the promotion of new games which cause the marketing expense to increase. In addition, the net income from investment-related projects and the profit of joint ventures increased significantly in Q2. Other net income was 4 billion and investment income from joint ventures was 2.37 billion yuan (FY2018Q2 : 1.25 billion; FY2019Q1 -2.96 billion).The company's FY2019Q2 net profit was 24.1 billion, up 35% from a year earlier, and the net interest rate was 27.17% (FY2018Q2 : 24.25%). Under NonGaap standards, The company's net profit rose 19 % to 23.5 billion from a year earlier, basically meeting our expectation and 2.5% higher than Bloomberg expectation. Non-GAAP profit rate attributed to equity holders of the company was 26.5%, higher than the past 3 quarters, and EPS was 2,49 while free cash flow was 20.7 billion, a 34% growth year-on-year. The amount of monthly active accounts of Wechat was 1.133 billion in FY2019Q2, a 7% growth year-on-year. QQ's smart- terminal monthly active accounts reached 707 million, which remained roughly stable compared with the same period last year.

Table 1、Differences between Industrial Securities Research Institute forecast and actual result in 2019Q2 Mn/RMB 2Q19A 2Q19E Diff(A/E-1) Revenue 88,821 93,171 -4.67% YoY(%) Cost of revenue -49,695 -50,708 -2.00% Gross Profit 39,126 42,463 Selling Cost -4,718 -6,149 Administrative expenses -12,577 -12,299 Non-GAAP Operating income 27,521 26,549 3.66% Non-GAAP Net income 24,136 23,820 1.33% Non-GAAP profit attributed to equity holders of the company 23,525 23,129 1.71%

Source：Company Disclosure, Industrial Securities Research Institute As of FY2019Q2, the company's value-added service revenue was 48.08 billion yuan, an increase of 14% over the same period last year, and the proportion of revenue fell to 54%. Financial technology and enterprise services increased by 37% to 22.88 billion over the same period last year, accounting for 25.77 percent of revenue, higher than the proportion of mobile games. Online advertising rose 16% to 13.377 billion from a year earlier, accounting for 18.5% of revenue, while other businesses accounted for 1.444 billion of revenue and 1.63 % of revenue. The revenue of the company's mobile games (including mobile games) + PC games reached 3.39 billion in Q2, and the proportion of revenue continued to decline to 38.17% (FY2018Q1: 41.4%).

Fig. 1、FY2018Q1-FY2019Q1 Tencent's revenues and growth rate Fig.2、FY2018Q1-FY2019Q1 Tencent’s segment revenue share QoQ

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100 million in RMB 300 100 million in RMB 35% 100% 32% 33% 90% 76 97 120 233 233 241 141 160 175 203 231 243 250 29% 30% 242 27% 80% 69 25% 101 110 200 179 24% 70% 124 107 165 141 162 134 164 142 20% 60% 170 150 17% 50% 15% 40% 100 351 10% 30% 368 421 399 469 421 440 437 490 481 50 5% 20% 10% 0 0% 0% 18Q1 Q2 Q3 Q4 19Q1 19Q2 17Q1 Q2 Q3 Q4 18Q1 Q2 Q3 Q4 19Q1 19Q2

Revenue QoQ(RHS) VAS Online Advitising Others

Source：Company Disclosure, Industrial Securities Research Institute Source：Company Disclosure, Industrial Securities Research Institute *Note: for ease of comparison, this "Others" is to restore the original report account

、 Table 2 Revenue share of each segment in FY2018Q1-FY2019Q1 FY2018 Q2 FY 2018 Q3 FY 2018 Q4 FY 2019Q1 FY 2019Q2 VAS 57.10% 54.65% 51.42% 57.30% 54.13% Online games revenues 34.21% 32.03% 28.50% 33.36% 30.74% Client games revenues 17.51% 15.39% 13.19% 16.15% 13.17% Mobile games revenues 16.70% 16.64% 15.31% 17.22% 17.57% Mobile games revenues including 23.89% 24.20% 22.38% 24.81% 24.99% mobile games comission Online games revenues including mobile 41.40% 39.58% 35.57% 40.95% 38.17% games comission Social network revenue 22.89% 22.63% 22.91% 23.94% 23.39% Financial technology and enterprise services - - 25.67% 25.50% 25.77% Online advertising 19.15% 20.16% 20.06% 15.65% 18.47% Media advertising 6.42% 6.32% 6.11% 4.07% 4.95% Social and other advertising 12.73% 13.84% 13.95% 11.58% 13.52% Others（Original Report） 23.75% 25.19% 28.52% 27.04% 28.37% Others（Current Report） 1.55% 1.63%

Source：Company Disclosure, Industrial Securities Research Institute

Expenses increased but lower than our expectation. In FY2019Q2, The sales and administrative expense rate of the company increased by about 1.3 percentage points from the previous month. The sales expenses rate increased due to the increase in promotion expenses, and the sales expense rate increased from 4.97% in FY2019Q1 to 5.31%. The general and administrative expenses rate increased slightly. (FY2019Q2: 14.16%, FY2019Q1:13.26%).

Due to the increase in investment income, the net profit attributable to parent company exceeded expectations, while the growth under NonGAAP was relatively rational. In FY2019Q1, the company's gross profit was 39.126 billion yuan, a year-on-year increase of 14%, a slight decline (-2%). The net profit attributable to parent company was 24.136 billion yuan, a year-on-year increase of 35%. Basic earnings per share was 2.55 yuan, NonGAAP net profit increased by 19% to 23.525 billion yuan, and NonGAAP EPS was 2.49 yuan. Mainly because other net income generated from investment-related projects and the profit of joint ventures increased significantly in FY2019Q2, among which other net incomes reached 4.038 billion yuan, and investment income from joint ventures reached 2.37 billion yuan, on the asset side, Tencent added 19.631 billion yuan in available-for-sale financial assets, with a total investment assets of 412.39 billion.

Fig. 3、FY 2018Q1- FY 2019Q1Tencents’ expenses Fig.4、FY2018Q1- FY2019Q1 Tencent’s gross profit and gross margin

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13.1% 13.2% 13.3% 13.3% 14.0% 12.8% 100 millions RMB 233 233 12.0% 250 35% 32% 33% 10.0% 179 29% 30% 8.1% 8.1% 7.7% 200 165 7.6% 25% 8.0% 24% 142 150 5.0% 20% 6.0% 17% 100 15% 4.0% 1.6% 1.9% 1.6% 10% 0.9% 1.3% 50 2.0% 5% 0.0% 0 0% 18Q1 Q2 Q3 Q4 19Q1 18Q1 Q2 Q3 Q4 19Q1 Net income attributable to Tencent marketing expense ratio administrative expense ratio Net income margin attributable to Tencent（RHS） financial expense ratio

Source：Company Disclosure, Industrial Securities Research Institute Source：Company Disclosure, Industrial Securities Research Institute

1. Game business: mobile games recover, regaining the growth of 20%+

The mobile games have maintained strong growth due to the increase in the number of new games. The PC games’ revenue has decreased due to long lifecycle of old games and lower commercialization as the result of improving user experience. Online game Q2 revenue (mobile game + PC game) was 33.9 billion yuan (including mobile phone revenue in social networks), an increase of 11.15% year-on-year, slightly lower than our expectation (13.5%); mobile game income (including commission) reached RMB 22.2 billion, up 26.1% year-on-year, in line with our expectations (25%), mainly due to 1) low base of FY2018Q2; 2) deferred income of FY2019Q1 good flow of " Arena of Valor"; 3) " Peacekeeper Elite ", "Perfect World Mobile" "Catchya" and other provides mobile phone business incremental income. “Peacekeeper Elite " DAU has exceeded 50 million; PC games fell 9% year-on-year, revenue reached 11.7 billion yuan, lower than our expectations, Mainly due to 1) long lifecycle of old games 2)the improvement of user experience of "DNF", its commercialization level was significantly reduced, but the "League of Legends" mobile game benefited from the skin sales growth. In addition, in June of this year, "League of Legends" launched a new game model " Teamfight Tactics", which drove the growth of DAU and user usage time.

Fig. 5、Tencent's mobile games revenues and growth rate YoY Fig. 6、Tencent’s PC games revenues and growth rate YoY 100 million in RMB 100 million in RMB 250 222 40% 160 15% 217 212 141 138 195 140 129 190 30% 10% 124 10% 200 28%176 26% 112 117 20% 120 5% 100 150 11% 12% 10% 80 0% 0% -2% 100 -2% 60 -4% -5% -10% 40 50 -9% -9%-10% -19% -20% 20 -13% 0 -30% 0 -15% 18Q1 Q2 Q3 Q4 19Q1 19Q2 18Q1 Q2 Q3 Q4 19Q1 19Q2

Tencent mobile game revenue QoQ(RHS) Tencent PC game revenue QoQ(RHS)

Source：Company Disclosure, Industrial Securities Source：Company Disclosure, Industrial Securities

Fig. 7、FY2008H1- FY2019H1 Actual income in Chinese game market Fig. 8、FY 2019H1 Users scale in Chinese game market

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1400 5 100 million 100 million in RMB 6 5.54 16% 46.41% 5.27 1163.1 4 14.46% 5.07 1200 4.89 14% 1050 5 4.59 39.10% 997.8 4 12% 1000 36.43% 3 4.01 33.99% 4 787.5 10% 800 30.14% 3 26.41% 26.70% 605.1 2 3 8% 600 21.95% 496.2 2 6.54% 18.45% 6% 2 400 338.9 1 5.12% 248.4 3.94% 4% 209.7 10.77%1 3.68% 200 123.8 156.5 1 89 5.23% 5 2% 0 0 0 0% 2008 H1 2009 H1 2010 H1 2011 H1 2012 H1 2013 H1 2014 H1 2015 H1 2016 H1 2017 H1 2018 H1 2019 H1 2014 H1 2015 H1 2016 H1 2017 H1 2018 H1 2019 H1 2008H1-2019H1 Actual income in Chinese game market YoY 2019H1 Users scale in Chinese game market YoY

Source：Company Disclosure, Industrial Securities Source：Company Disclosure, Industrial Securities

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180 百万美元 8 6.7 160 7 140 6 5.6 5.6 4.8 120 5 4.3 4.3 100 4 3 80 2 60 1 40 0 20 Arena of Valor Peacekeeper Clash of Clans Mini World AniPop Total game Elite 0 201901 201902 201903 201904 201905 201906 201907 Arena of Valor Peacekeeper Elite Clash of Clans PUBGmobile + 和平精英堡垒之夜荒野行动 Mini World AniPop Total game

资料来源：SensorTower，兴业证券经济与金融研究院整理 Source：Trustdata, Industrial Securities

Table 3、Tencent key mobile games in FY2019 Name Type Independent/Agency Manufacturer Domestic/Import On-line Time Game for Peace FPS Independent Tencent Domestic 8 May 2019 Perfect world MMORPG Agency Perfect World Domestic March 6 2019 Let's catch the demon RPG Independent Tencent Domestic 11 April 2019 11 April 2019 The second round of Sword net 3: fingertips MMORPG Agency Seasun Domestic testing, Expected to launch in June Yin Han Rachel ARPG Agency Domestic Public test in April 19 Technology On January 8, 2019, the internal test Tencent， Call of Duty Action Independent Domestic of the national service was Activision completed. Test of limited number and deletion Dungeons and the Warrior M RPG Agency NEOPLE Import of files on January 3, 19 Game of Thrones·Winter is YOO ZOO SLG Agency Domestic 19Q2 internal test coming Games Limited deletion test opened on Loong Dragon fantasy RPG Agency Domestic March 27, 2019. Appointment in Entertainment progress. Fox demon, little matchmaker RPG Independent Tencent Domestic - Agency /Client LINEAGE 2 MMORPG NC SOFT Import - Game IP Agency / Client Stone Age MMORPG Netmarble Import - Game IP Moonlight Blade MMORPG Independent Tencent Domestic Internal testing in March 2019

Source: CNG, Industrial Securities

Industry situation: The FY2019H1 game industry recovered, with a year-on-year increase. According to gamma data, the actual sales revenue of China's game market reached 161.31 billion in January-June FY 2019, and the year-on-year growth rate returned to double digits of 10.8%. The actual sales revenue of mobile game market was 75.31 billion yuan, up 18.8% year-on-year. 6.7%, also higher than the growth rate of the same period last year. In the first quarter of this year, due to the new warfare of the " Arena of Valor", the selling of the game skin and the stable income contribution of "Fantasy Westward Journey" and the promotion of "PUBG Mobile", " Peacekeeper Elite", "Perfect World Mobile" and other new explosions ,sales revenue still maintains growth. The growth rate of users of FY2019H1 reached a new high of three years. In the first half of FY2019, the number of users in the Chinese game market was approximately 554 million, a year-on-year increase of 5.1%, and the growth rate reached a three- year high (2017: 3.7%, 2018: 3.9%).

"Winner Winner Chicken Dinner" was a big hit in both domestic and foreign markets. According to

请务必阅读正文之后的信息披露和重要声明 - 6 - 证券研究报告 COMPANY RESEARCH SensorTower, excluding China's Android revenue, PUBG Mobile's total revenue reached 860 million US dollars, of which "Peacekeeper Elite" revenue accounted for 28%, about 241 million US dollars. In particular, in July this year, "Peacekeeper Elite" + "PUBG MOBILE" revenue reached 167 million US dollars, increase year-on-year 748% (previous year: 0.46 billion US dollars). Comparing with similar games, "PUBG Mobile" since April gained revenue which reached 3-5 times revenue of "Fortnite" and "Wild Action" ‘s.

The daily number of starts of Tencent's games is leading the market. According to Trustdata, the number of daily starts of “Arena of Valor” is 6.7 times, leading the mobile game market, followed by the Peace Elite (5.6 times).

In the second half of the year, we expect that because of the deferral of core games in the second quarter and the growth of new games in the third quarter, mobile games will continue to maintain strong growth in the second half year, and the growth rate is expected to exceed 30%. In June of this year, "League of Legends" launched a new game model " Teamfight Tactics", so the PC game had deferral revenue and would recover in next half year.

2. Fin-tech is imperative

Revenue from financial technology and corporate services increased by 37.3% year-on-year to 22.9 billion RMB. Excluding interest income from provision, financial technology and corporate services revenue increased by 57% year-on-year. It was Mainly driven by commercial payments, other financial technology services (such as microfinance) and cloud business. However, since the remaining provision has been transferred to the People's Bank of China since mid-January, the interest income of the balance of the payment is no longer available, which has caused the growth rate of financial technology and corporate services to slide to 37%. We estimate that the interest income of FY2018Q2 reserves will reach 1.8 billion, and this part of the income has not been withdrawn after the reserve ratio of reserve funds reached 100% in January this year, so it has relatively affected the growth rate of revenue of this business.

Fig. 11、Tencent’s other businesses growth rate Fig. 12、FY2019Q12Global Cloud Infrastructure Market Competition Map

300 100 million in RMB 25% Others 13.7% 242 243 250 19%231 20% 203 16% 15% 200 175 China Telecom 160 13% 6.8% 10% 10% 150 Baidu Cloud 5% 5% 8.0% 100 0% Ali Cloud 50 -4% -5% AWS 47.3% 8.8% 0 -10% 18Q1 Q2 Q3 Q4 19Q1 19Q2

Other revenue QoQ(RHS) Tencent Cloud

15.4% Source：Company Disclosure, Industrial Securities Source：Synergy Research Group, Industrial Securities *Note: for ease of comparison, this "Others" is to restore the original report account  Tencent Cloud: FY2019Q1 global share reached 2%, China's share exceeded 15% and Tencent is vigorously developing financial cloud in Q2. In FY 2019Q1, global cloud computing infrastructure spending jumped 42% compared to last year. In FY2019Q1, Tencent Cloud global cloud infrastructure market share reached 2% (competitors: AWS 33%, Microsoft 16%, Google 8%, IBM 6%, Alibaba Cloud 5%). In addition, according to Canalys information, Tencent Cloud gained 15.4% market share in China's cloud infrastructure. In the second quarter of FY2019, Tencent Cloud signed the contract with PICC, Bank of Communication and Haitong Securities in the financial 请务必阅读正文之后的信息披露和重要声明 - 7 - 证券研究报告 COMPANY RESEARCH cloud field. In addition, Tencent launched the cloud-based "WeCity Future City" solution in July to provide smart industry solution support for public services in several cities including Changsha, such as healthcare, transportation and education. At present, Tencent Cloud's infrastructure has covered 25 regions on five continents, operating 53 Availability Zones, deploying more than 1 million servers worldwide, with peaking bandwidths of 100T.

 The number of commercial payment users, merchants, GMV and income in financial technology and enterprise services have all grown rapidly. In addition, as of FY2018Q2, the total customer assets of Tencent “Li Cai Tong” have exceeded RMB 800 billion.  Mini program platform expands and QQ Mini program launched in the second quarter of FY2019. In November 2018, the QQ mini programs had been tested on the Android side for a small range of grayscale and went live in June FY2019. The WeChat applet ecosystem has grown every day. According to Questmobile, the number of MAU>5 million WeChat mini programs increased by 35.3% to 180, while the number of MAU>1 million WeChat mini programs doubled to 883 year-on-year; in addition, the mini programs MAU increased rapidly by 51.9% to 746 million from 491 million in the same period last year. At the same time, the average monthly usage time also increased by 23.3% to 63.93 minutes.  Mini game stickiness is gradually enhanced. In the half year period, the 7-day retention rate of Mini games increased from 18.4% at the end of last year to 23.4% in June this year, and the average monthly usage time also increased (33.4 minutes). As a major component of small programs, small games. User habits of using mini games during fragment time are gradually being developed to deepen user stickiness. Fig. 13、 WeChat mini program number (MAU > 5 million) Fig. 14、 WeChat mini program number (MAU > 1 million)

单位：个单位：个 200 180 1200 +35.3% 883 150 133 900 +99.8% 100 600 442

50 300

0 0 2018-06 2019-06 2018-06 2019-06

Source：QuestMobile, Industrial Securities Research Institute Source：QuestMobile, Industrial Securities Research Institute

Fig. 15、WeChat mini program Fig. 16、WeChat mini program usage monthly

单位：亿单位：分 12 90钟 63.93 7.46 8 60 51.84 +23.3% 4.91 4 30

0 0 2018-06 2019-06 2018-12 2019-06

Source：QuestMobile, Industrial Securities Research Institute Source：QuestMobile, Industrial Securities Research Institute

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Fig. 17、 WeChat mini program weekly retention rate Fig. 18、 WeChat mini program average monthly active time 30.0% 40.0 单位：分钟 23.8% 24.0% 23.4% 33.4 21.5% 18.4% 18.6% 30.0 28.0 20.0% 16.4%

20.0 10.0% 10.0 0.0% 0.0 2018-12 2019-06

Source：QuestMobile, Industrial Securities Research Institute Source：QuestMobile, Industrial Securities Research Institute

Table 4、Mini program data comparison Daily Active Monthly Active Number of service providers Cover Industry Wechat Mini Program 250million 620million 8.2 thousand 200+ Cumulative number Mini program Daily Active Mini program users scale Alipay Mini Program of users number 230million 640million 100million 200 thousand+ Mini program Monthly Active Developer number Open source alliance member Baidu Mini Program number 180million 80 thousand 24 100 thousand+ Desktop icon Cover equipment Monthly Active Open times Quick App retention

100million 200million 200million 100million Source：Aladdiny Index, Industrial Securities Research Institute 3. Reduced advertiser demand & increased industry advertising inventory resulted in pressure on online advertising revenue

Macro environmental issues challenge & increased industry advertising inventory made Internet advertising revenue under pressure, with growth rate below 20%, lower than our expectations. 2019 Q2, the revenue of online advertising business increased by only 16% year-on-year to 16.4 billion RMB. Among them, social and other advertising revenue growth rate is less than 30% (28%) to 12 billion RMB; media advertising revenue fell by 7% year-on-year to 4.4 billion yuan because there was the high base revenue of the business of last year's World Cup, and on the other hand, advertisers have reduced their media advertising investment with relatively low ROI and the deferred series of episodes. However, the information flow advertisements in Tencent's video have achieved significant growth year-on-year and quarter-on-quarter.

In 2019, advertiser marketing budget is a new low in a decade. According to a survey conducted by the National Advertising Research Institute and CTR, FY2019 witnesses the lowest budget in a decade of advertiser marketing spending. The proportion of advertisers who are expected to increase their advertising investment has dropped to 33%, while it is greater than 35% in the first nine years, with an average of 51%. The proportion of advertisers expected to reduce advertising spending rose to 22%, with an average of 16% in the past decade. On the other hand, there is also a media-to-media transfer of advertiser marketing expenses. The migration from display ads to effect ads is the future trend, and advertisers are more inclined to channels with higher ROI. As a result, the investment in digital media is on the rise, and in Internet advertising there is also pressure on long video ads with relatively low ROI.

Several episodes were postponed and the cost of video content was relatively low, resulting in a significant increase in advertising gross margin. In addition, in FY2019Q2, the gross profit margin of the company's online advertising increased significantly to 48.6% (FY2018Q2: 37.36%, FY2019Q1: 41.87%), mainly because of the delay in broadcasting of several episodes and the relatively low cost of video content.

In the second half of the year, we expect that media advertising will continue to be under pressure in the second half year, but the growth rate of social advertising will maintain nearly 30%. We are

请务必阅读正文之后的信息披露和重要声明 - 9 - 证券研究报告 COMPANY RESEARCH optimistic about the accelerated turned-to-revenue ability of the high ROI business due to the release of advertising inventory of WeChat ads (including friends circle + official accounts + mini program).

Fig. 19、Tencent's online advertising revenue Fig. 20、Media advertising, social and other advertising revenue 100 million in RMB 170 180 162 164 50% 140.0 100 million in RMB 118.0 120 160 40% 111.6 141 38%134 120.0 140 32% 93.8 99.0 30% 100.0 120 107 22%20% 73.9 100 15% 80.0 10% 80 60.0 47.3 50.9 52.0 0% 44 60 33.0 34.8 -10% 40.0 40 -14% 20 -21% -20% 20.0 0 -30% 0.0 18Q1 Q2 Q3 Q4 19Q1 19Q2 18Q1 Q2 Q3 Q4 19Q1 19Q2

Online Advertsing QoQ (RHS) Social and other Advertising Media Advertising

Source：Company Disclosure, Industrial Securities Source：Company Disclosure, Industrial Securities

4. Digital content subscriptions are still in high-speed growth, but growth is slowing slightly

The company's Q2 social network revenue was 20.773 billion yuan, a year-on-year increase of 23.16%, a slight increase of 1.52% from the previous quarter. The main contribution came from in-game virtual item sales and live broadcast business. The video subscription service grew strongly in the current period. The registered account for fee-added services increased by 9.7% year-on-year to 168.9 million. The number of subscribers for video services reached 96.9 million in FY2019Q2, achieving a year-on- year increase of 30%. The company still maintains a leading position in the video industry.

Fig. 21、Tencent’s social network revenue Fig. 22、Tencent’s fee-based VAS subscriptions 1.69 250 100 million in RMB 15% 1.80 1.66 1.54 1.54 1.60 205 13.0% 207 1.47 195 1.60 1.35 200 182 10% 169 1.40 1.19 1.18 1.25 8.1% 6.7% 1.20 150 5% 1.00 0.80 100 1% 0% 0.60 50 -5% 0.40 -6.8% 0.20 0 -10% 0.00 Q2 Q3 Q4 19Q1 19Q2 17Q1 Q2 Q3 Q4 18Q1 Q2 Q3 Q4 19Q1 19Q2

Social Network QoQ (RHS) Fee-based VAS subscription

Source：Company Disclosure, Industrial Securities Source：Company Disclosure, Industrial Securities

 Tencent Video: Subscriber growth rate has maintained a high growth rate of 30%, but due to the delayed impact of popular dramas, the growth rate of subscribers has slowed slightly. According to QuestMobile, 2019Q2, Tencent video MAU reached 553 million, an increase of about 10% (FY2018Q2: 503 million), with penetration rate of 57.4%. Tencent video achieved a 30% year-on- year growth in the amount of subscribers. Because of popular dramas’ delay, the growth video subscription accounts has slowed down. According to Yunxiang Data's four-image analysis system, the view amount of Tencent Video's exclusive broadcast episodes and shows in the first six months of this year were 21.8 billion/1.9 billion, respectively, a certain gap compared to iQiyi (36.9 billion/2.2 billion).

However, in the sports field, a total of 490 million users watched the NBA2018-2019 seasons through the Tencent platform , a number nearly three times that of the 2014-2015 season. it has driven the advertising and subscription account income to some extent.

请务必阅读正文之后的信息披露和重要声明 - 10 - 证券研究报告 COMPANY RESEARCH Fig. 23、Mobile video user scale penetration Fig. 24、FY 2019H1 Tencent Video's exclusive broadcast episodes and shows

400 369 350

300

2019/1/1 95.9% 250 218 200

150 124

100 2018/1/1 94% 50 22 25 19 20 11 4 0 7 0 1 0 0 93% 94% 94% 95% 95% 96% 96% 97% iqiyi Tencent Youku Mango TV Sohu PPTV LeTV video exclusive broadcast episodes （100million）（） exclusive broadcast shows 100million Source：Company Disclosure, Industrial Securities Source：Company Disclosure, Industrial Securities

Fig. 25、Comparison on App MAU Fig. 26、Proportion of long video panoramic traffic user scale 2019/6 penetration 57.7% 57.4% 43% Users (10K) 60,549 59,112 44,994 rate 6 5.56 5.53 单位：亿 5.27 100% 6.4% 5.03 4.96 2.2% 6.6% 5.2% 5 4.15 80% 4 60% 3 96.1% 96.2% 95.1% 40% 2

20% 1

0 0% iqiyi Tencent Video Youku iqiyi Tencent Video Youku APP Wechat Mini Program Baidu Mini Program Alipay Mini Program 2018/6/1 2019/6/1

Source：Company Disclosure, Industrial Securities Source：Company Disclosure, Industrial Securities

 Tencent Music: Revenue slows down, the payment rate is strong, and the pan-music entertainment eco appears

 1) FY 2019Q2, Tencent Music's total revenue reached 5.9 billion yuan, year-on-year increase of 31% and decrease of 2.67% quarter-on-quarter. Slightly lower than Bloomberg's unanimous expectations; 2) Online music service revenue reached 1.562 billion yuan, a slight decline in proportion (up to 26.5%), an increase of 20.25% year-on-year. Member subscription revenue reached 800 million yuan (yoy: 31.5%) while others Revenue reached 762 million yuan (yoy: 10.3%). Social entertainment service revenue reached 4.336 billion yuan, an increase of 35.3% year-on-year and a 5% increase from the previous month. 3) Sales & management expense ratio totaled 17.8%; 4) gross profit margin was 32.9%, down 2.5 percentage points from the previous month while Non-IFRS net profit was 1.13 billion yuan and Non-IFRS net profit margin was 19.1%.

请务必阅读正文之后的信息披露和重要声明 - 11 - 证券研究报告 COMPANY RESEARCH Fig. 28、FY2017Q1 -FY2019Q2 TME’s online music service revenue Fig. 27、FY2017Q1 -FY2019Q2 TME’s segment revenue break down

Source ： Company Disclosure, Industrial Securities Research Source：Company Disclosure, Industrial Securities Research Institute Institute

Fig. 29、FY2017Q1 -FY2019Q2 TME’s segment MAU Fig. 30、FY2017Q1 -FY2019Q2 TME’s segment paying ratio

Source：Company Disclosure, Industrial Securities Research Institute Source：Company Disclosure, Industrial Securities Research Institute

2) The paying user rate has increased strongly, the MAU has declined slightly quarter-on-quarter, and the ARPPU has remained stable. In FY 2019Q2, the number of monthly active users of online music business reached 652 million, down 0.3% from the previous month; the payment rate increased to 4.8%, up 0.5 percentage points from the previous month and the paid users reached 311 million; the company's online music monthly ARPPU was 8.6 yuan. Compared with RMB 8.7 in the same period of last year, it decreased by 1.1%, but it increased by 0.3 yuan quarter-on- quarter. At present, the total number of paid users of Tencent Music is ranked only behind Spotify and Apple Music, ranking third in the world.

3)Diversified content expands; "video +" is established cross-border,and pan-music entertainment ecological highlights. Tencent Music established the "Video +" alliance in the third quarter of last year. As of the second quarter of FY2019, it has released nearly 100 songs for over 20 TV dramas. In addition, Tencent's original musician platform has accumulated nearly 400,000 songs. with a total broadcast volume of 100 billion, and the daily broadcast volume has increased by 200%. In addition, the company has added more audio-visual variety shows, such as "Bands’ Summer", "Sound into the Heart 2", short videos , audio products and other expanded content.

5. Investment Proposal: adjust the target price to HK $407.4 to maintain a " Outperform " rating.

We used the DCF model to revalue the company's stock, and the DCF model fed back the downgrade of the earnings forecast, (WACC=10%,Perpetual g 2%), according to the calculation, Tencent's discounted FCFF, excluding investment, has a total equity value of 2.67 trillion yuan. In addition, Tencent Video and Tencent Cloud, which contribute negative cash flow, are valued according to the corresponding assets of Tencent Investment, which are given 1.5x PB, and Tencent Cloud. The total 请务必阅读正文之后的信息披露和重要声明 - 12 - 证券研究报告 COMPANY RESEARCH share price is HK $407.4.

Table 5、Tencent ’s FCFF forecast (in thousand RMB) FY2016 FY 2017 FY 2018 FY 2019E FY 2020E FY 2021E EBIT 49,904,000 66,222,000 76,365,000 94,714,387 108,471,367 124,392,250 (excluding investments ) Tax rate -19.74% -17.85% -15.33% -15.50% -15.50% -15.50% NOPLAT 40,053,662 54,403,158 64,657,953 80,033,657 91,658,305 105,111,451 add: Share-based 4,313,000 6,137,000 7,869,000 9,452,180 10,397,398 10,917,268 compensation expenses add: Depreciation and 12,646,000 23,502,000 34,248,000 51,461,230 58,843,575 66,030,695 amortization gross operating cash flow 57,012,662 84,042,158 106,774,953 140,947,067 160,899,278 182,059,414 less: additional working 43,466,000 -21,811,000 -14,239,000 -6,731,958 -14,910,650 -16,816,042 capital net operating cash flow 13,546,662 105,853,158 121,013,953 147,679,025 175,809,927 198,875,455 less: capital expenditure 12,100,000 12,768,000 23,941,000 34,714,450 43,393,063 52,071,675 FCFF 1,446,662 93,085,158 97,072,953 112,964,575 132,416,865 146,803,780

Source：Industrial Securities estimates

Table 6、DCF Valuation Discounted cash flow FCFF Valuation % of value (thousands) First stage 265,874,847 7.88% Second stage 1,159,047,972 34.34% Third stage(Final value) 1,188,569,171 35.22% AEV 2,613,491,990 77.44% less: net liabilities 111,157,000 -3.29% less: non-controlling 35,005,557 -1.04% interests 209,004,265 6.19% add: cash Total equity value 2,676,333,698 add: value of Tencent's 618,585,000 18.33% investments add: value of Tencent Video 50,000,000 1.48% add: value of Tencent Cloud 30,000,000 0.89% value-added total equity 3,374,918,698 100% value Total shares(thousands) 9,520,971 stock price(RMB) 354.47 stock price($HK) 407.4

Source：Industrial Securities estimates

Table 7、Tencent’s income statement annual forecast (in million RMB) FY2016 FY 2017 FY 2018 FY 2019E FY 2020E FY 2021E Revenues 151,938 237,760 312,694 380,907 474,413 576,845 Growth rate 47.71% 56.48% 31.52% 21.81% 24.55% 21.59% Cost of revenues -67,439 -120,835 -170,574 -212,940 -268,381 -331,892 Gross profit 84,499 116,925 142,120 167,968 206,032 244,953 Growth rate 38.00% 38.37% 21.55% 18.19% 22.66% 18.89% Interest Income 2,619 3,940 4,569 5,483 7,676 10,362 Other(losses)/gains, net 3,594 20,140 16,714 Selling and marketing -12,136 -17,652 -24,233 -20,840 -34,074 -42,110 expenses Proportion of income -7.99% -7.42% -7.75% -5.47% -7.18% -7.30% 请务必阅读正文之后的信息披露和重要声明 - 13 - 证券研究报告 COMPANY RESEARCH General and administrative -22,459 -33,051 -41,522 -52,413 -63,487 -78,451 expenses Proportion of income -14.78% -13.90% -13.28% -13.76% -13.38% -13.60% EBIT 56,117 90,302 97,648 117,579 130,781 151,426 Finance costs, net -1,955 -2,908 -4,669 -6,135 -6,626 -1,303 Shares of profit/(loss) of -2,522 821 1,487 1,893 2,285 2,680 associates and joint ventures Profit before income tax 51,640 88,215 94,466 113,337 126,439 152,804 Income tax expense -10193 -15744 -14,482 -16,215 -19,608 -23,685 Profit 41,447 72,471 79,984 97,122 106,832 129,119 Growth rate 42.39% 74.85% 10.37% 21.43% 10.00% 20.86% Non-GAAP profit attributable to equity holders of the 45,420 65,126 77,469 97,380 115,269 137,611 company Growth rate 40.14% 43.39% 18.95% 21.28% 18.37% 19.38% Profit attributable to equity 41,095 71,510 78,719 94,814 104,220 124,600 holders of the company Growth rate 42.66% 74.01% 10.08% 20.45% 9.92% 19.55% Profit attributable to non- 352 961 1,265 93,980 112,028 135,483 controlling interests

Source：Industrial Securities estimates

Table 8、Tencent ’s income statement quarterly forecast (in million RMB) FY2019Q1 FY2019Q2 FY2019Q3 FY2019Q4 FY2020Q1 FY2020Q2 FY2020Q3 FY2020Q4 Revenues 85,465 88,821 101,080 105,542 105,347 110,760 126,575 131,731 Cost of Revenues -45,645 -49,695 -57,360 -60,240 -59,010 -62,482 -71,472 -75,415 Gross profit 39,820 39,126 43,720 45,302 46,336 48,278 55,103 56,316 Selling and marketing -4,244 -4,718 -5,863 -6,016 -7,374 -7,975 -9,240 -9,485 expenses Proportion of income -5.0% -5.3% -5.8% -5.7% -7.0% -7.2% -7.3% -7.2% General and -11,331 -12,577 -14,151 -14,354 -14,011 -14,620 -17,467 -17,388 administrative expenses Proportion of income -13.3% -14.2% -14.0% -13.6% -13.3% -13.2% -13.8% -13.2% EBIT 36,742 27,521 26,640 26,676 34,225 32,005 32,142 32,409 Finance costs, net -1,117 -1,982 -1,582 -1,454 -1,206 -2,141 -1,676 -1,542 Profit before income tax 32,668 27,909 26,299 26,462 33,589 30,436 31,036 31,439 Income tax expense -4,812 -3,225 -4,076 -4,102 -5,206 -4,718 -4,811 -4,873 Profit 27,856 24,684 22,222 22,360 28,383 25,718 26,226 26,566 Profit attributable to equity holders of the 27,210 24,136 21,667 21,801 27,674 25,075 25,570 25,902 company Non-controlling 646 548 556 559 710 643 656 664 interests Non-GAAP operating 28,470 27,281 27,917 27,152 32,666 31,946 32,506 32,799 profit Non-GAAP profit 21,673 24,191 26,004 25,191 28,935 27,446 29,346 29,542

Source：Industrial Securities estimates

Investment Proposal: Adjust the target price to HK $407.4 and maintain " Outperform". We adjusted revenue from 397.5 billion / 505.8 billion to 380.9 billion /4.7448 billion in 19-20 and adjusted Non- GAAP Net Profit from 94.7 billion / 119.8 billion to 93.9 billion /112 billion in 19-20. Based on the DCF model, we adjusted the target price to HK $407.4 (original target price: HK $421.3), corresponding to 35/30x PE, of FY2019/FY2020 under NonGAAP standard. Maintain " Outperform " rating.

Potential risk：Policy regulatory risks; the growth of the game business has slowed. The leading game water decline risk of the company, the new game flow performance does not meet the expected risk, the online game realization rhythm slows down the risk; the advertising business falls short of the expected risk; the financial index decline risk such as ROE, gross profit margin; the organizational structure adjustment does not meet the expectation; The risk of decreasing the length of use of Tencent

请务必阅读正文之后的信息披露和重要声明 - 14 - 证券研究报告 COMPANY RESEARCH products.

请务必阅读正文之后的信息披露和重要声明 - 15 - 证券研究报告 COMPANY RESEARCH

Appendix

Balance sheet RMB in millions Income statement RMB in millions Fiscal year 2018E 2019E 2020E 2021E Fiscal year 2018E 2019E 2020E 2021E Current assets 217,080 275,936 353,036 459,636 Revenues 312,694 380,907 474,413 576,845 Inventories 324 404 510 630 Cost of revenues 170,574 212,940 268,381 331,892 Accounts receivable 46,920 60,013 73,250 87,285 Gross profit 142,120 167,968 206,032 244,953 Cash and cash equivalents 97,814 143,496 207,253 299,699 Interest income 4,569 5,483 7,676 10,362 Other current assets 72,022 72,022 72,022 72,022 Other gains, net 16,714 15,485 14,633 16,671 Selling and marketing 24,233 20,840 34,074 42,110 expenses General and administrative Non-current assets 506,441 583,902 683,895 785,649 -41,522 -52,413 -63,487 -78,451 expenses Property, plant and equipment 35,091 47,472 58,043 67,184 Operating profit 97,648 117,579 130,781 151,426 Construction in progress 4,879 3,879 3,879 3,879 Finance costs, net -4,669 -6,135 -6,626 -1,303 Share of profit of Investment properties 725 755 785 815 associates and joint 1,487 1,893 2,285 2,680 ventures Land use rights 7,106 8,924 10,705 12,451 Profit before income tax 94,466 113,337 126,500 152,804 Intangible assets 56,650 57,990 64,794 71,876 Income tax expense 14,482 16,215 19,608 23,685 Investments in associates 227,790 280,683 335,967 391,647 Profit for the period 79,984 97,122 106,893 129,119 Profit attributable to Non- Available-for-sale financial assets 135,221 145,221 170,743 198,817 1,265 2,309 2,672 4,519 controlling interests Profit attributable to Other Non-current assets 38,979 38,979 38,979 38,979 equity holders of the 78,719 94,814 104,220 124,600 Company Non-GAAP profit Total assets 723,521 859,838 1,036,931 1,245,286 attributable to equity 77,469 93,980 112,028 135,483 holders of the Company Current liabilities 202,435 230,341 268,594 309,565 EPS(RMB) 8.27 9.96 10.95 13.09 Accounts payable 107,047 126,953 155,206 186,177 Non-Gaap EPS(RMB) 8.43 9.87 11.77 14.23 Borrowings 26,834 34,834 44,834 54,834 Other current liabilities 68,554 68,554 68,554 68,554 Key Financials Non-current liabilities 164,879 174,879 189,879 209,879 Fiscal year 2018E 2019E 2020E 2021E Long-term payables 87,437 97,437 112,437 132,437 Growth(%) Other Non-current liabilities 77,442 77,442 77,442 77,442 Revenue 31.5% 21.8% 24.5% 21.6% Total liabilities 367,314 405,220 458,473 519,444 Operating profit 21.5% 18.2% 22.7% 18.9% Equity attributable to equity 323,510 419,613 539,168 681,400 Net income 10.4% 21.4% 10.1% 20.8% holders of the Company Net income attributable to Share capital and Share premium 27,294 27,294 27,294 27,294 equity holders of the 10.1% 20.4% 9.9% 19.6% Company Shares held for share award -4,173 -4,173 -4,173 -4,173 Profit Margin (%) schemes Treasury shares 729 729 2,154 2,344 Gross Margin 45.5% 44.1% 43.4% 42.5% Retained earnings 299,660 395,763 513,893 655,935 Non-Gaap Net Margin 25.7% 25.6% 24.3% 23.9% Non-Gaap Net Margin Non-controlling interests 32,697 35,006 39,290 44,442 attributable to equity 24.8% 24.7% 23.6% 23.5% holders of the Company Total equity 356,207 454,619 578,458 725,842 ROE 28.9% 21.4% 18.5% 17.8% Total equity and liabilities 723,521 859,838 1,036,931 1,245,286 ROA 11.1% 11.3% 10.3% 10.4% Solvency test (%) Cash Flow Net asset ratio 103.1% 89.1% 79.3% 71.6% Fiscal year 2018E 2019E 2020E 2021E Debt ratio 50.8% 47.1% 44.2% 41.7% Profit before tax 94,466 113,337 126,500 152,804 Current ratio 1.07 1.20 1.31 1.48 Depreciation and amortization 34,248 51,461 58,844 66,031 Quick ratio 1.07 1.20 1.31 1.48 Interest expense 4,669 6,135 6,626 1,303 Operation(times) Change of working capital -10,302 -13,093 -13,237 -14,034 Assets turnover 43.2% 44.3% 45.8% 46.3% Others -16,638 -15,933 -12,282 -12,934 Accounts payable turnover 0.15 0.16 0.15 0.15 CF from operating 106,443 141,907 166,451 193,169 Per share (RMB) CF from investing -151,913 -106,062 -118,721 -119,996 Non-Gaap EPS 8.4 9.9 11.8 14.2 CF from financing 35,380 9,837 16,027 19,273 EPS 8.3 10.0 10.9 13.1 BPS 34.0 44.1 56.6 71.6 Net change in cash and cash -10,090 45,682 63,757 92,446 Multiple(x) equivalents Cash and cash equivalents 105,697 97,814 143,496 207,253 PE(Non-Gaap) 34.1 29.1 24.4 20.2 beginning of the year Cash and cash equivalents end of 97,814 143,496 207,253 299,699 PB 8.5 6.5 5.1 4.0 the year

请务必阅读正文之后的信息披露和重要声明 - 16 - 证券研究报告 COMPANY RESEARCH Introduction of Share Investment Rating Industry Investment Rating When measuring the difference between the markup of the industry index and that of the market’s benchmarks (Shanghai Composite Index/Shenzhen Component Index) within twelve months after the release of the report, we define the terms as follows:  Overweight：Industry performs better than that of the whole market；  Neutral：Industry performs about the same as that of the whole market；  Underweight：Industry performs worse than that of the whole market Company Investment Rating When measuring the difference between the markup of the company stock price and that of the market’s benchmarks (Shanghai Composite Index/Shenzhen Component Index) within twelve months after the release of this report, we define the terms as follows:  Buy： With a markup more than 15% better than that of the market；  Outperform：With a markup 5% to 15% better than that of the market；  Neutral： With a markup less than 5% better or worse than that of the market；  Underperform： With a markup more than 5% worse than that of the market. Information Disclosure The Industrial Securities Co., Ltd. fulfills its duty of disclosure within its sphere of knowledge. The clients may visit the column of Insider Trading Prevention and Control at www.xyzq.com.cn for the arrangement of the quiet period and the affiliates’ shareholdings. Important statement The information contained in this report is derived from public information. We do not warrant the accuracy and completeness of such information, nor do we guarantee that the information and recommendations contained will never change. We have tried our best to be objective and fair about the content of this report. The opinions, conclusions and recommendations in the article do not constitute any bid or offer price for the target securities. Our company and the author are not responsible for any investment decision made by the investor. 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