The Good Problems WeChat is Causing Tencent

Peter is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

The Chinese internet giant Tencent Holdings (NASDAQOTH: TCEHY.PK) introduced a blockbuster mobile chat application that is being perceived as a significant threat to the revenues of social networking firms such as Sina's (NASDAQ: SINA) Weibo, as well as Chinese telcos like China Mobile and China Unicom. WeChat is doing now what Tencent’s QQ did about a year ago: eating massive amounts of the nation’s 2G bandwidth, but on much larger scale. The app is only about a year old but it has certainly created a lasting impression.

The Chinese Ministry of Industry and Information Technology (MIIT) held a closed meeting with representatives of both China Mobile and China Unicom about two months ago, to discuss telco  subsidies amid the rise of several Over-the-Top (OTT) services. Although the meeting ended without any agreement, it was obvious that its focus was on WeChat.

Fear the 'Dumb Wire'

Back in April, a comment from MIIT’s Miao Wei created uproar among the WeChat users when he said that Chinese telecom operators might force Tencent to start charging fees for WeChat, as the increasing usage of the app was creating pressure on data bandwidth. Tencent has recently quashed the rumors by announcing that the firm will keep its popular mobile chatting app free. Interestingly, users are already paying for the increased use of bandwidth. The reasons given by the state minister would have made sense if WeChat’s approximately 260 million Chinese users and 40 million international users were getting free internet from telecom operators. But they are not.

What the advanced features of these OTT services is doing is inducing customers to switch towards 3G, which is has higher margins for telcos, but consumers are slipping away from traditional telephone services. This is the same worry that is gripping carriers in the U.S. over VoLTE – Voice over LTE – and other VoIP applications like Skype, which is that their high-margin cellular voice minutes are rapidly becoming worthless to consumers and the carriers do not have the networks to handle the traffic.

The business models of the telcos are having to respond to rapidly changing consumer behavior. In 2012, the total number of SMS messages sent by an average Chinese user dropped by 9% from 2011 levels as a direct result of OTT services in general, and WeChat in particular. China Mobile, which is the world’s largest telecom operator, has a competing product, Fetion, that it would rather promote. But it is WeChat’s other features, including voice and video chat, that is putting pressure on the carriers, turning them against their will into a ‘dumb wire’ like network that simply passes data; their spare capacity is being filled up faster than they are comfortable with.

The Chinese micro-blogging leader, Sina, has also admitted that it is facing increasing competition from WeChat on mobile devices. Sina’s Weibo is China’s answer to Twitter, and dominates the country’s social networking scene. But WeChat’s success can be gauged with a comparison to Weibo’s empire of 424 million users, having grown to 60% of that in just under 2 years.

Showing everyone the money

Tencent so far hasn’t figured out a way to monetize WeChat and that is the long-term underlying issue. Even Microsoft advertises on free installs of Skype. But fundamentally, Tencent is in great shape as its recent earnings report shows quite clearly, and I’m sure the firm is looking for ways to integrate WeChat into the rest of its product portfolio. 

Q1 results were impressive on the strength of its online gaming portfolio, which includes the massively popular League of Legends.  Net profit rose 36.9% year-over-year to ¥4.04billion ($658 million) and revenue was up accordingly -- approximately 40% -- to ¥13.55 billion ($2.2 billion).  More importantly, WeChat now boasts 194 million active users, up from 157.9 million at the end of 2012 which is an annualized growth rate of 91.2%.  No wonder everyone is worried.

Of course, there is the real possibility that Tencent could be forced to pay a fee to China’s powerful telecom sector --essentially China Mobile – to continue WeChat’s development.  At that point, the firm would be forced to create a monetization scheme. But with hefty cash reserves that exceed $2 billion, Tencent has plenty of time and money to figure out the problems being caused by WeChat’s success, especially with its numerous cash cows. Tencent’s president, Martin Lau, is adamant that WeChat’s users won’t pay any additional fees, so the firm is prepared to ride out any push back from China Mobile and with these growth numbers there is no need for him to break that promise at this point. 

How to play

If you are not inclined to by pink sheet ADRs, then there are a bevy of ETF's that are suitable to gain exposure.  Tencent is the third largest holding in the GlobalX Social Media Index ETF (NASDAQ: SOCL) and the largest holding of Guggenheim China Technology ETF (NYSEMKT: CQQQ). Both are small, with less than $32 million AUM between them. SOCL is up 11.1% on the year, while CQQQ is up 20.7%, mostly due to Tencent and its 9.1% weighting.  Meanwhile, the biggest Chinese ETF, the $6.5 billion FTSE China 25 Index Fund (NYSEMKT: FXI) has been recently restructured and now includes Tencent as its fifth largest holding with a weighting of 5.67% and investors there should be cheering this addition.

I have been a fan of this company for more than a year now and think it is well positioned in both the gaming – with the acquisition of Riot and Epic Games. Now with a strong social networking presence Tencent may just be the best consumer-related stock in Asia for the foreseeable future.  WeChat is still in its infancy and its game and game asset portfolio -- it owns the Unreal gaming engine -- place it in a great growth position across a number of potential gaming platforms, including mobile. 

Peter Pham has no position in any stocks mentioned. The Motley Fool recommends SINA . The Motley Fool owns shares of China Mobile and Microsoft. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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